The Eligible Passive Company Rule (the "EPC Rule") is a familiar concept in the world of SBA lending, but the nuances are sometimes overlooked.  In general, SBA prohibits loans to "passive businesses owned by developers and landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds."  But SBA makes an exception for eligible passive companies, or EPCs as they are more commonly known.  An EPC may obtain SBA loan proceeds to purchase or lease and/or improve or renovate real or personal property that it leases to an operating company(ies) (the "OC") for the OC to use in its business.  An EPC may also use SBA loan proceeds to refinance debt incurred for these purposes.  But an EPC is not permitted to use loan proceeds to purchase a business, acquire stock in a business or acquire any intangible assets of a business or to refinance debt incurred for any of these purposes.

Most lenders are familiar with some of the basic requirements of the EPC Rule, such as:

• The EPC must lease 100% of the real or personal property to an OC.
• The lease must have a term equal to or greater than the term of the loan.
• The EPC can not make a profit on the lease payments from the OC - i.e. the lease payments can not exceed the amount of the loan payment plus a reasonable amount to cover the EPC's costs and expenses of holding and maintaining the property, such as maintenance costs, property taxes and insurance.

SOP 50 10 5(F) (the "SOP") at pages 104-106 further sets forth the requirements related to the EPC Rule and specific provisions related to EPCs.  Although most lenders are familiar with these basic requirements, lenders must still be careful in applying the rule to their specific loans and must pay attention to the nuances.  For example, SBA prohibits multiple EPCs in a transaction.  Borrowers sometimes prefer to form a separate real estate holding company for each property that they purchase.  If an SBA loan is being used to finance two properties, the loan will not be eligible if the borrower forms two separate EPCs.

When determining if an EPC/OC loan structure is appropriate for a given loan, it is important to look at the purpose of the loan and the proposed use of loan proceeds.  For example, if the loan is solely to acquire a business or provide working capital, and no part of the loan proceeds will be used to purchase real or personal property (such as equipment) or renovate property, an EPC/OC structure would not be eligible for SBA financing.  A borrower may have an affiliated real estate holding company that is pledging real property as secondary collateral to secure the loan, but the loan should not be structured as an EPC/OC loan.  The real estate holding company in this particular example should not be considered an EPC and can not be a borrower on the loan (as it would be an ineligible SBA applicant), but instead the real estate holding company can be a guarantor on the loan.

As the SOP states, because the EPC Rule is an exception to the rule that passive entities may not receive SBA guaranteed financing, it is interpreted strictly. It is important that lenders understand the nuances of the EPC Rule and interpret the rule correctly because failure to do so will often lead to a denial of the SBA guaranty.

For questions regarding the EPC Rule, contact Katie at 267-470-1207 or kobrien@starfieldsmith.com.