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An ongoing investigation into Small Business Association (SBA) “liar loans” provided by banks to franchisees has all three sides – franchisees, franchisors and banks – pointing fingers. The investigation revealed that some banks had prior agreements with franchisors to service their franchisees’ SBA loans regardless of the qualifications, and loan officers would not diligently evaluate the loan applications. Now, franchisees that are being held responsible for failed loans are arguing that franchisors provided false projected earnings so that the franchisees would get their loans. The problem is causing a shakeup at the SBA and could mean wholesale changes with how banks provide loans that require approval based on projected earnings. For more on this continue reading the following article from Blue MauMau.

Franchisees of Huntington Learning Center, The Coffee Beanery and more say that the system was stacked against them. What irks them is that their franchisors had access to the real numbers while they struggled to get a scrap of financial information, any information, from a single store.After they signed their franchise agreement, bogus financial projections were released and often orchestrated by their franchisor for their loans. Although they were held completely accountable, the system was built to hide the numbers until it was too late. Nor did any of the agencies facilitate the deal for the franchisee. The bank who was paid by the borrower, the loan broker who was paid by the borrower, and the franchisor who was paid by the franchisee or even the government, did not really care how accurate those numbers were.

Remember mortgage liar loans that largely benefited the lenders who took their fees out early? The loans later collapsed. In franchising, bogus numbers meant to meet SBA lending hurtles are issued. In many cases, all parties except for the borrower, the franchisee, seem to know how useless the financial projections are and how at risk the franchise is. This is the fifth of a five-part series on SBA liar loans given to franchisees.

What set of books do I want you to see?

The franchisees vehemently argue that they have been set up. "Huntington knew the revenues generated from their business did not meet SBA standards," says John, a former Huntington Learning Center franchisee who does not want to release his name for fear that his franchisor may retaliate. "They knew all the time what the average store numbers were, but they released or didn't release numbers depending on who wanted to know. We were all given numbers that were purposely skewed in order to get us the loan and for Huntington to make a franchise sale."

"My franchisor had purposely sat on top of the information that we needed in order to make an informed decision," says Randy, another former Huntington Learning franchisee who prefers to use a pseudonym.

Toronto-based attorney Michael Webster elaborates. Webster runs a website that looks into how frauds are perpetrated. As strategic chairman of a trade group that advises independent franchisee associations, he also is an expert on franchise matters. He thinks at the heart of the issue is a structure of gaps that looks like it provides disclosure but actually hides information from the person most at risk — the franchisee. He says that the business plan with future earnings projections is typically not shown to the franchisee until after the franchise agreement is signed and the franchisee is committed. The cases that Blue MauMau looked into were that way. Webster observes that sometimes it is not even until an SBA guarantee is obtained that a franchisee sees the projections because it contains confidential information from the franchisor. "This despite the loan packager being the agent of the franchisee," says Webster. The loan packager, also known as a lending broker, is typically paid a fee of thousands of dollars by the franchisee borrower to apply for and facilitate the loan.

Webster says earnings are typically known by franchisors since they have to collect royalties from store revenues and have operations managers that are devoted to help lift the performance of franchised stores, so they gather the information.

"Average store earnings are known to the franchisor, who has the confidential information already packaged up, and will only release it if the franchisee signs that he has not seen, will not see, and if seen will not rely upon the franchisor's projections," observes the fraud expert. In essence, Webster thinks that these franchise liar loans are encouraged by a gap in pre-sales and post-sales disclosure laws. The attorney argues that it creates fertile ground to defraud franchise investors. "The franchisor shouldn't be able to tell the SBA one thing with their inputs into the business plan, and then turn around and tell the state franchise regulators that they don't have an earnings claim."

"The reality of the current system is that it has developed to the point in which there are often really two sets of financial projections," observes New York attorney Paul Steinberg. One set goes to state regulators to fulfill their disclosure requirements and another goes to the federal government in order to receive loans.

Steinberg thinks there is a problem when a franchisor and their recommended vendors (e.g. loan brokers) knowingly give false earnings estimates to banks and then a franchisee is given a loan. "Bogus numbers shouldn't be allowed to be given through the back door, " states Steinberg.

A new bar: SBA insists earnings forecasts cannot be pie-in-the-sky

The Small Business Administration responded to its Office of Investigator General that it will follow its recommendations. The SBA is seeking $2.1 million on ten defaulted Huntington Learning loans from Banco Popular and will monitor all SBA-backed loans for which the bank applies. The SBA reminds preferred lenders of its requirements not to use pie-in-the-sky forecasts but "to use and assess the feasibility of realistic projections." It will issue an Information Notice reminding its preferred lenders of the need to provide accurate data to the SBA in the loan origination process which is supported by published, historical data. Experts think that although the requirement may have been on the books, its enforcement is essentially a new bar for lenders.

"I think the Inspector General is overreaching," Coleman says emphatically. "Projections by definition is a projection."

But the SBA has made it clear that it doesn't want projections that are pie-in-the-sky numbers. They need to be rooted in historical reality. Lenders will also be expected to continue to uphold the SBA operating standard of collecting annual profit statements from borrowers. "That is a routine requirement for all borrowers. Generally annual tax returns are acceptable," observes Ms. Barbara Arena, a 25-year veteran of small business lending and vice president of Granite State Development Corporation, a lender of SBA 504 loans.

Liar loans may bring change to banking>

If liar loans are practiced widely in the industry, the issue isn't so much the amount of loans involved, thinks one well-known small business economist and management scholar, who prefers to be unnamed, keeping him clear of the franchise controversy. He thinks the big issue is the potential hit to reputation and the changes that it may bring to banking.

For example, what will happen to loans to franchisees as a result?  Will all franchisees have trouble getting loans because money tightens in response to the problem?  Does the small business guarantee become more difficult for all franchisees to get?  Will all small businesses be affected?  What about the number of people they employ or an overall cut in franchisee employment?

The economist emphasizes that the negative result of these liar loans "lies in the reputation multiplier," where a few bad loans can influence the credibility and practices of a whole industry. Depending on how bad the problem is, SBA loans to franchises could become extremely difficult to obtain.

Robert Tingler, a former Illinois assistant attorney general and state franchise law regulator, remembers a time when the SBA didn't want to get involved with franchise loans.

"Originally the SBA was not interested in making franchise loans," declares Tingler. "Eventually they showed some interest in loans, but they did not take the time to understand the franchise business model."

One result of the SBA's concerns was the initiation of a registry of franchise brands which showed that their franchises were independent businesses that were not controlled solely by their chain. The SBA was not set up to lend to large company-owned branches, but rather to independent small businesses. "The SBA did not like the division of ownership and control that resulted from the franchisor/franchisee relationship,” declares Tingler.

Tingler points out that the current problem of franchise liar loans has been created by the Small Business Administration itself. “They made unrealistic demands, which included financial projections that had to show a profit in the first year or two that a franchise was in business. That is a virtually impossible standard." 

Franchise attorney Rifkin thinks that liar loans like those made to Huntington Learning Center franchisees, which have been guaranteed by the SBA, will end up changing the landscape in franchising. "I think a lot of lawyers are going to get a lot of business from this. This is going to be a huge issue for franchising," declares the attorney. "It is going to have a big impact on the ability of many franchisors to find franchisees. This is going to dominate the franchise landscape. It is going to force some big changes — in the way banks do business and the way franchisors do business. Those franchisors who cannot provide satisfactory evidence that franchisees are going to be able to make money and fulfill the terms of their loans will not be able to stay in business. This is going to root out a lot of bad apples."

This article was republished with permission from Blue MauMau.


Read the rest of the five part series.