SBA Lenders Accountable for ‘Liar Loans’

It has come to light that many banks that made Small Business Association (SBA) loans between 2000 and 2010, which are backed by taxpayer dollars, failed to exercise …

It has come to light that many banks that made Small Business Association (SBA) loans between 2000 and 2010, which are backed by taxpayer dollars, failed to exercise due diligence in making said loans to franchisees. In many cases, banks made loans based on inflated earnings projections that should have been better reviewed. It is now clear that banks would often have agreements with the franchise to service loans for all of its prospective franchisees around the country, with a lack of emphasis on whether the loan should have been made or could be paid back. Insiders argue it was because of an understanding that franchise loans are safer than independent small-business loans, but the SBA’s own report shows that loans in both categories carry the same amount of risk. Now, lenders are facing lawsuits for the estimated $1.6 billion in bad SBA loans over the past 10 years. For more on this continue reading the following article from Blue MauMau.

Franchisees aren’t the only ones who have been hurt by bad SBA liar loans backed by tax payer dollars.For all of the supposed due-diligence of lenders working closely with franchise loan brokers and franchisors to gather better information, it looks like bankers may have also been hit in the end by these bogus loans with unfounded, pie-in-the-sky financial projections.

This is the fourth of a five-part series.

Banks and lenders of government-guaranteed loans to franchise owners are running away in droves from a national platform, where they service a particular franchise brand nationwide, to a relational banking model, where they better know the community and the borrower. And as evidence that it isn’t just a bad economy causing the change, consider this. SBA lenders in droves are now demanding earnings claims in franchise disclosure documents before they lend, and surprisingly, they are getting it.

Lending consultant Robert Coleman observes that major bankers and lending packagers worked just like Banco Popular. "The world was different in 2007 and 2008. These lending deals were being done with a lot looser scrutiny than they are being done today. Back then you had five or six national lenders who would do a franchise-specific concept anywhere in the country."

Companies like CIT or Banco Popular would work closely with a specific franchise brand and then lend to small business owners that raised the brand’s flag, no matter where in the country those businesses were.

"The national platforms (that lent to franchisees) have fallen apart," declares Barbara Arena, vice president of Granite State Development Corporation, a lender of SBA 504 loans. Many small business bankers that lent to franchise systems on a national basis lost their jobs.

Coleman, editor of a trade journal for small business bankers, Coleman Publishing, thinks that franchise lenders have disappeared nationally for a couple of reasons. "The regulators went after them because of (loan) losses," he declares. But he also adds, "Bankers discovered that the business underwriting that Banco Popular had with franchisors didn’t work."

Is there evidence that these puffed-up franchise loans cost the banks dearly?

Arena, who is a 25-year veteran of small business lending, working for such companies as CIT before it filed for bankruptcy in 2009, doesn’t see it from her position. She thinks that the move from a national platform to community banking is because of the shift in the economy. "My perspective as a remote employee solely focused on one piece of CIT’s larger platform, is that a big failure was CIT’s funding model. Commercial and residential lenders took a big hit. CIT filed for bankruptcy because, in my opinion, their funding model was flawed. They relied on funding from the secondary market."

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The secondary market is an aftermarket in which loans are bundled into securities and financial instruments, where they are sold to investors.

Bankers want earnings claims disclosed, franchisors jump

It is not just franchisees that are scratching their heads trying to figure out why they didn’t even reach half of the projection numbers. Banco Popular confirms that part of the problem of finding out why the Huntington Learning loans didn’t work out is that their former small business loan officers are now gone. "This is a very piecemeal thing, where people are tracking back to see what happened. It’s hard to piece together when people are no longer with us," said the company spokesperson of the bank’s attempt to understand how it could have so many bad Huntington loans. She adds, "We aren’t the only ones going through major overhauls, restructuring and reorganization."

These days, banks are being more studious when it comes to franchise loans. "Lenders couldn’t even spell UFOC five years ago," declares Coleman. The bank advisor emphasizes that franchise loans have shifted to a community model, in which the banker has a relationship with the borrower and knows the community that the new business will be put in. "Today lenders want to know why a franchisee is buying a new Cold Stone Creamery when there is one half a mile down the road that is in bankruptcy," he says. "They are doing their homework."

Darrell Johnson, founder and president of research firm Frandata, which studies and reports on franchising activity, thinks that although bankers may be paying more attention to verifying information from the Franchise Disclosure Document, they still need to be careful about relying on it. Johnson cautions bankers: "a Franchise Disclosure Document’s purpose, as defined by the Federal Trade Commission, is not to provide lenders information on the credit risk of the franchise. Rarely do franchisors provide a level of detail that would allow a lender to independently assess unit projections."

What is the result of bankers trying to do some degree of due diligence themselves by asking franchisors to disclose earnings in their Franchise Disclosure Documents?

According to publisher Robert Bond of World Franchising, a provider of franchise data, potential franchise owners and borrowers have been asking for store earnings to be included in disclosure documents for decades. Bond tracks earnings numbers. "The current percentage of franchisors that provide some sort of store financial performance representation is 40 percent, which is up from 20 percent from three to four years ago," says Bond. "Earnings claims had been under 20 percent for the past ten years or so before that," declares Bond of the static state of franchisors who provided claims in the past. The recent emphasis of bankers on corroborating earnings projections from Franchise Disclosure Documents may explain why the number of franchisors disclosing earnings figures has jumped over the past four years.

>Franchises and independent small business have the exact same risk

Despite all of the hype on how franchise chains should be safer for banks because they provide more information for businesses under a brand’s flag, the reality is that the risk is the same as SBA loans made to all small businesses. That’s judging from the SBA’s own report covering October 2000 to September 2010, which calculates loan charge-offs (see chart) for franchise brands and industry categories with ten disbursements or more. The charge-off is four percent for all small businesses as well as for franchised businesses alone. Charge-offs come from loans that  the SBA has recognized as nonperforming, moving the unpaid amount from its receivables to its uncollectible loan account.

Ms. Arena reminds us that although these charge-off numbers in the aggregate may be interesting, banks don’t lend in the aggregate.  Each franchise and brand has to be evaluated in the industry sector that it is in. For example, failure rates of Dunkin’ Donuts shops needs to be compared with failure in the retail bakery North American Industry Code sector.

Fraud or sloppiness?

The SBA chided Banco Popular on its lack of homework in giving out the failed, taxpayer-supported business loans to Huntington Learning franchises. Ten out of twelve failed. "The lender disregarded relevant and available data, which indicated that the franchises’ revenue projections were unreasonable," wrote SBA Assistant Inspector General for Auditing John Needham. "This was due, at least in part, to the lender’s perception that franchise loans require a lesser degree of due diligence because of the established business model of franchise systems." The bank erroneously thought franchises were a safer investment than independent small businesses so little to no due-diligence was done on the loans. The internal auditor continued, "Had the lender complied with SBA’s requirements to use and assess the feasibility of realistic projections, the 12 loans should have been declined."

Regarding the problems with Banco Popular and the industry, Coleman says, "Banco Popular did some things wrong. And maybe they weren’t acting in a reasonable and prudent manner and that is why they are going to lose their guarantee. But to go the next step and say that this is fraud? NO! If you want to use the word sloppy, then go ahead and use the word sloppy, but it is certainly not fraud."

"This is fraud," replies attorney Rifkin emphatically. Two weeks ago Rifkin filed a lawsuit for fraud on behalf of franchisees Welshans and Williams against Maryland-based Sandy Springs Bancorp. The pair’s current complaint against franchising firm The Coffee Beanery and its officers was amended to include racketeering.

Costs? $1.6 billion to taxpayers, bank lawsuits coming

Lawsuits against other banks will follow.

Says Randy, a former Huntington franchisee who prefers to remain anonymous: "My franchisor purposely sat on top of the information that we needed in order to make an informed decision."

Former Illinois franchise regulator Robert Tingler speculates that there could be civil liability. "I am assuming the Justice Department could bring a criminal case against the lender and the franchisor if the facts prove a scheme to defraud a bank and or the SBA," he declares. "Considering all the financial crimes committed from 2007 to the present that have not been prosecuted, and probably never will, I would guess that it would take a very big public stink over a lot of money before the SBA loans would prompt a criminal case."

Of a list of 583 franchise brands from 2000 to 2010, there has been $1.6 billion cost to tax payers in SBA charge-off fees for failed franchise loans, not including brands that have small disbursements under ten loans.

Coleman says that inflated projections in loan applications are no big deal. "During boom times, bankers had nothing to lose so why the need to look at realistic earning projections for a store?" points out Coleman. "In the past, the reality was that if you put X amount down and pledged your house, you got the loan," observes the founder of Coleman Publishing.

This article was republished with permission from Blue MauMau.

Read the rest of the five part series.

  •  Part 1: SBA Rebukes Banco Popular for Liar Loans
  • Part 2: Franchise Liar Loans Spread among Banks
  • Part 3: Advice on SBA Liar Loans



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