‘Liar Loans’ Plague SBA

“Liar loans,” described as loans that don’t meet Small Business Association (SBA) criteria yet get approved anyway, are a continuing problem for the organization. The Office of the …

“Liar loans,” described as loans that don’t meet Small Business Association (SBA) criteria yet get approved anyway, are a continuing problem for the organization. The Office of the Inspector General (OIG) has released another report criticizing the SBA for poor oversight over franchise loans, and its contents reflect concerns the OIG has brought to the SBA as far back as 2001. Then, as now, the OIG warned organization representatives that franchisors had an incentive to encourage as many prospective franchisees as possible to buy into the business and seek funding despite their inability to properly assess the franchise’s profitability. For more on this continue reading the following article from Blue MauMau.

The Small Business Administration’s Office of Inspector General published yet another study highlighting the SBA’s oversight failures as financial institutions continue underwriting franchise loans that do not meet SBA lending criteria.   In a study by the OIG dated July 2, 2013, it was determined that the SBA "had not implemented a program or process to effectively monitor risk in its loan portfolio. Additionally, the SBA had not developed a policy to ensure that identified risks were addressed." (pg 3) SBA Risk Mgmt July 2013

SBA knows franchises have inordinately high loan failure rates

Selecting three specific franchise systems with inordinately high franchise default rates, the OIG pointed to the continued flow of SBA loans to these systems as proof of unacceptable oversight procedures. Under these three franchise systems five hundred and one loans defaulted – that’s five hundred and one families financially ruined by franchise systems that clearly had no right in obtaining SBA loans. However, the SBA has known for years of the risks associated with not just franchise loans but with franchisors themselves:

"Moreover, a previously mentioned SBA-funded study found that a franchisor must reach a minimum efficient scale to lower its (as opposed to a franchisee’s) costs. Given this necessity plus the need to collect franchisee-paid fees, franchisors have an incentive to encourage as many prospective entrepreneurs as possible to become franchisees and find financing. Moreover, there is always a risk of some franchisors’ overly optimistic financial projections enabling underqualified prospective franchisees to obtain and default on – SBA guaranteed loans." Page 2 SBA OIG 2002 Report

Again, this was stated in 2002!

The OIG’s stated ‘fear of risk’ of "franchisor’s overly optimistic financial projections" came to pass and proved by the OIG in July 2011 in its review of Huntington Learning Center Loans:

"Banco Popular approved these loans based on first-year projections that showed that the franchises would generate revenues ranging from $483,000 to $650,025 (Pg 4). . . In addition, we reviewed literature published by the Franchisor that showed that the actual average first-year revenue for HLC franchises in 2007 was $262,272(Pg 5). . . If Banco Popular had complied with SBA’s requirements and used revenue projections that were realistic, the 12 HLC franchise loans should have been declined due to lack of repayment ability." (Pg6)

SBA not following own recommendations

So, just what are "SBA’s requirements?"

"In accordance with 13 CFR 120.150, applicants must be creditworthy and loans must be so sound as to reasonably assure repayment considering past earnings, projected cash flow, future prospects, the ability to repay the loan with earnings from the business, and the effects of any affiliates.6 Guidance in effect at the time of the loans in question, SBA’s SOP 50 10 4, required lenders to use realistic projections of future earnings when historical financial information did not demonstrate borrower repayment ability. The SOP further required lenders to test the feasibility of projections against industry averages and historical information with an explanation for significant deviations. " Pg 4 SBA July 2011 Report

The ramifications for Banco Popular’s blatant disregard of SBA underwriting requirements were made unequivocally clear by the OIG:

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"SBA stated that the National Guaranty Purchase Center (NGPC) will review the 10 defaulted loans by July 25, 2011 and will seek recovery of all purchase amounts disbursed if recovery is appropriate under the facts of each case and consistent with SBA loan program requirements. If the NGPC concludes that recovery is not warranted, the cases will be referred to the Office of Risk Management for resolution. These proposed actions are responsive to the recommendation. However, we also recognize that SBA typically only reviews early-defaulted loans for weaknesses in a lender’s repayment ability analysis. Given the systemic issue noted in this report and the clear violation of SBA’s policies and procedures by Banco Popular in originating HLC franchise loans, we believe all 10 defaulted loans should be reviewed with the same heightened scrutiny and the lender’s inadequate repayment ability analysis should be considered material to the default of these loans" (Pg 9).

The OIG specifically stated that the SBA should seek recovery of all guarantees paid out to Banco Popular on these loans.

Yet nothing was done.

Did SBA’s knowledge of franchise loan failure begin in 2002? Not according to an LA Times article from 1996:

"a recent study of 138 franchising chains that began operations in 1983 found that only a quarter of them were still in business 10 years later. . . Another recent study found that while large corporate franchises tend to be successful and profitable, smaller ones usually aren’t. These fail at a higher rate than independently owned businesses. . . The findings are contained in two reports recently released by the Small Business Administration Office of Advocacy in Washington."

Beginning in 1993, six reports commissioned or performed by the SBA/SBA OIG’s office have found that SBA franchise loans fail at the same rate if not higher than non-franchise loans. The six reports include: Dr. Tim Bates 1993, Dr. Scott Shane 1996, SBA OIG 2002 (two separate studies – OIG and SBA Office of Financial Assistance {OFA}), a 2009 SBA OIG investigation into Huntington that was referred to the Attorney General’s Office and the SBA OIG July 2011 Huntington report. Further, in September 2012, the SBA published "The Small Business Advocate" monthly newsletter (Vol 31, No. 6). On page 2 of the FAQ section it stated:

"Survival among independent businesses and franchises appears to be similar, as they have similar age distributions."

There are now at least seven reports over three decades (1990’s, 2000’s, 2010’s), performed by three different groups (outside commissioned authors, SBA OIG, SBA OFA), using three different data sets (SBA in house database, SBA database scrubbed with independent tests {see pg 13 paragraph’s 2 & 3 of 2013 report}, and census bureau/bureau of labor statistics info (monthly newsletter}) all showing that franchises fail at the same rate – if not higher – than non-franchised businesses. This new 2013 report red flags the laissez-faire/growing incompetence of the SBA to perform its required duties.

Despite what salesmen of franchises may want you to believe, there is no federal government study that shows the chances of being successful in franchised businesses as being better than those of non-franchised businesses. None.

What is more worrisome is an additional study performed by the Government Accountability Office (GAO) uncovering a deeply unsettling trend in the SBA’s Patriot Express loan program. This program provides SBA financing for veterans of the U.S. Armed Forces.

"Patriot Express loans valued at about $703 million have defaulted at a higher rate than loans under the Small Business Administration’s (SBA) other related loan guarantee programs, and losses for Patriot Express have exceeded its income." Pg 1 GAO Patriot Loan Study

VetFran is a program devised by the franchisor community that sells discounted franchise systems to veterans. Knowing the Patriot Express program gives almost automatic loan approval to our service men and women, franchisors have targeted these individuals – just as SBA franchise loan approvals for the average citizen have become more difficult to obtain over the last few years. It would be interesting to see if a further study is done to pinpoint exactly what industries the increased default rates are hitting and whether franchising is part of the problem.

SBA now starts hiding franchise loan information

The SBA OIG found "that the Agency had not yet established a framework or process for portfolio risk management, even though risk management and improved program oversight was part of the Agency’s Strategic Plan, and the OCRM’s mission." To compound their problems, the SBA is now refusing to release SBA Franchise Loan Default Rates to the public. Not only are they claiming their data ‘is faulty’, which was clearly stated in their 2002 report and yet nothing has been done to cure it, they are now stating that should the data be proven correct it will still not be released because  ? they… don’t…have to. The SBA is now hiding franchise loan default data, after having been shown to be ignoring their own underwriting Standard Operating Procedures, and allowing unqualified loans to be guaranteed by taxpayers in order to enrich the underwriting financial institutions and a cadre of franchisors whose systems can only be financed through fraudulent revenue numbers.

Lastly, this is not the final word on SBA franchise lending.

The timing of this report is rather curious. What prompted the SBA OIG to begin an investigation in March of 2012? Is there a reason for the OIG to have this published in July of 2013? Time will tell just how important the calendar was to the making, and releasing, of this report.

This article was republished with permission from BlueMauMau.


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