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How to Document Borrower Equity
Injections for the SBA Loan
By Bob Coleman
Editor, Coleman Report
[email protected]
Overview
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Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
2
Equity Injection Fraud
1. False Equity Injection
Based on OIG loan fraud investigations, false equity
injection is a significant and recurring problem. False
documents submitted to verify the required equity injection often include:
a) False gift letters or gift affidavits,
b) False promissory notes and standby agreements
c) False financial statements, or
d) False bank statements and cashier checks.
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
3
Equity Injection Fraud
a) Gift letters and gift affidavits (investigation often proves
such “gifts” to be false – either the money does not exist,
or it is never paid into the business, or it is subsequently
repaid to the donor).
b) Tax returns reporting income that does not seem to support the required equity injection,
c) Bank statements that upon close inspection appear to
have been altered,
d) Bank account records showing a recent, unexplained,
large dollar deposit into the borrower's account, and
e) Credit reports showing a poor credit history for a borrower
who claims to have substantial cash.
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
4
Equity Injection Fraud
There are many ways a borrower or loan
agent may attempt to falsify the equity
injection or conceal the actual source of funds.
OIG investigations have often determined that
the cash injected was actually borrowed, and
that the related debt was not disclosed to the
lender or SBA.
5
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
Equity Injection Fraud
When lending officials are suspicious that
equity injection verification documents may be
false, it is suggested that lenders take
affirmative steps to detect and deter such
fraud such as the following:
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
6
Equity Injection Fraud
●
If a gift letter is involved, have both the donor and the
borrower sign an affidavit detailing the alleged gift and
stating that the gift does not have to be repaid or returned,
and request that the borrower provide a copy of a bank
statement showing the injection was made prior to
disbursement
●
If funds are being transferred by wire (especially from a
foreign country), request a copy of the wire transfer and
include it in the loan file, and
●
If an inheritance is cited, verify that the funds exist by
obtaining a copy of the inheritance bank statement
showing the funds exist prior to disbursement.
7
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
Equity Injection Fraud
The OIG encourages lenders to take proactive
steps in order to reduce fraud, including such
measures as having borrowers sign a
certification at closing detailing the equity
injection requirements for the SBA loan, and
specifically how they have been met, and
verifying with bank records that the equity
injection is actually put into the business prior
to disbursement, and used by the business.
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
8
Equity Injection Fraud
SBA OIG recommends consideration of the
following practices and internal controls to
deter and detect suspicious lending activity:
●
Development of sufficient management
oversight of loan approvals, including the
use of multiple “eyes” reviewing the
underlying documents that are used in
generating credit approval memoranda, at
least on larger dollar loans.
9
SBA Information Notice Control No.: 9000-1793 Effective: 4-7-2009
Overview
●
Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
10
Setting Borrower Equity Requirements
Setting the LTV/equity requirement is a function
of credit policy to define parameters about various lending channels, borrower conditions and
collateral demographics. Equity policy constraints can reveal plenty about the credit culture of the organization and will determine how
regulators approach portfolio supervision. How
much is enough ‘equity’ is never answered for
sure until the loan is repaid. Or charged-off.
Charles Green, Coleman Report
Volume 22, Number 3 --Issue #583 January 20, 2014 11
Setting Borrower Equity Requirements
A lender’s loan policy is expected to define
boundaries to lending practices in adherence to
applicable regulations. The FDIC and other regulators provide broad outlines of suggested
CRE leverage limitations, or “supervisory LTV”
(SLTV) guidelines. The SBA suggests lenders
adhere to their own policies, but that’s not intended to be a ticket to stupid.
Charles Green, Coleman Report
12
Volume 22, Number 3 --Issue #583 January 20, 2014
Setting Borrower Equity Requirements
LTV/equity guidelines can only provide a
framework to assess specific loan risks.
What is Loan Risk?
Charles Green, Coleman Report
Volume 22, Number 3 --Issue #583 January 20, 2014 13
Setting Borrower Equity Requirements
1. Business history: Is it a seasoned company,
intermediate stage growth company or start-up?
2. Financial results: Are there steady revenues
and profits, growing sales with profits beginning
or projected success?
3. Management depth: Does borrower have solid track record, only industry exposure or did
they just lose their job?
Charles Green, Coleman Report
Volume 22, Number 3 --Issue #583 January 20, 2014
14
Setting Borrower Equity Requirements
4. Business plan: Is there a fully developed
plan, a general idea shared by managers or is
borrower still working on it?
5. Industry: Is it manufacturing, wholesale, retail
or service?
6. Business sector: Is it always in demand,
niche oriented, seasonal or so cutting edge that
no one’s ever heard about it?
Charles Green, Coleman Report
Volume 22, Number 3 --Issue #583 January 20, 2014
15
Setting Borrower Equity Requirements
7. Collateral: Is it obsolete, mature, functional
or to-be-built?
8. Location: It is a high grade site, acceptable
site or is borrower still looking for it?
9. RE Improvements: Is it a generic commercial space, limited-use or single-purpose?
Charles Green, Coleman Report
Volume 22, Number 3 --Issue #583 January 20, 2014
16
Setting Borrower Equity Requirements
The point? Equity requirements/LTV are not just
about property or asset types. Equity measures
the protection hedge that collateral offers the
lender against many different kinds of credit
risks. Automatically judging every deal is a category the same without genuine qualification is
flying blind.
Charles Green, Coleman Report 17
Volume 22, Number 3 --Issue #583 January 20, 2014
Setting Borrower Equity Requirements
Equity is a means to temper credit risk by using
borrower’s cash investment as a means to lower
lender exposure to multiple business risks.
Recognition and adherence to regulator/agency
guidelines is a smart and necessary tactic to
maintain a balance between the business of
lending and responsibility to the source of
lender funding/guaranty.
Charles Green, Coleman Report
18
Volume 22, Number 3 --Issue #583 January 20, 2014
Setting Borrower Equity Requirements
504 Borrower’s Contribution
1. The borrower must inject at least 10% of the Project cost.
2. New businesses must inject at least 15%.
3. Businesses with a Limited or Special Purpose Property also must inject 15%.
SBA considers only the following as a Limited or Special Purpose Property:
a) Amusement parks;
b) Bowling alleys;
c) Car wash properties;
d) Cemeteries;
e) Clubhouses;
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Pg 241 SBA SOP 50 10 5(F) Effective January 1, 2014
Setting Borrower Equity Requirements
f) Cold storage facilities where more than 50% of total square footage is equipped for refrigeration; g) Dormitories; h) Farms, including dairy facilities; i) Funeral homes with crematoriums; j) Gas stations; k) Golf courses; l) Hospitals, surgery centers, urgent care centers and other health or medical facilities; m) Hotels and motels; n) Marinas; o) Mines; p) Museums; q) Nursing homes, including assisted living facilities; r) Oil wells; s) Quarries, including gravel pits; t) Railroads; u) Sanitary landfills; v) Service centers (e.g., oil and lube, brake or transmission centers) with pits and in ground lifts; w) Sports arenas; x) Swimming pools; y) Tennis clubs; z) Theaters; and aa) Wineries Pg 242 SBA SOP 50 10 5(F) Effective January 1, 2014
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Setting Borrower Equity Requirements
●
If a Project finances both a New Business and a Limited or Special Purpose Property, the applicant is required to inject 20% of the project cost.
●
The additional borrower’s contribution will reduce the SBA’s portion of the financing.
●
The borrower’s equity in land previously acquired may be counted toward the borrower’s contribution. The borrower also may count toward its contribution, equity in land and buildings that will be part of the Project if they are adding a new building to the same property.
Pg 242 SBA SOP 50 10 5(F) Effective January 1, 2014
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Overview
●
Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
22
Equity Injection 101
_____Lender has made a personal loan to an individual for
the purpose of providing an equity injection into the business.
(Loan is not eligible to be submitted under delegated
authority.)
Pg 9 SBA Form 1920 (Revised 2-14)
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Equity Injection 101
SBA Express Loans
1. The credit decision, including how much to factor in a past
bankruptcy or whether to require an equity injection, is left to
the business judgment of the lender.
2. If the lender requires an equity injection and , as part of its
standard processes for non-SBA guaranteed loans verifies the
equity injection, it must do so for SBA Express loans.
3. Lenders must adhere to the requirement that owners of
20% or more must inject equity into the business above certain thresholds.
Pg 36 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
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Equity Injection 101
An SBA-guaranteed loan may be used to finance a change of
ownership that includes intangible assets.
1. If the purchase price of the business includes intangible assets (including, but not limited to, goodwill, client/customer
lists, patents, copyrights, trademarks and agreements not to
compete) in excess of $500,000, the borrower and/or seller
must provide an equity injection of at least 25% of the purchase price of the business for the application to be processed under delegated authority. (Seller equity is defined as
seller take-back financing that is on full standby (principal and
interest) for a minimum of 2 years.)
Pg 122 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
26
Equity Injection 101
2. The borrower and seller will agree how much equity each
will provide. For example, the borrower and seller may each
provide half of the equity or the borrower may provide 15%
and the seller may provide 10%.
3. If the purchase price of the business includes intangible assets of $500,000 or less, b)(1) immediately above does not
apply.
4. If the purchase price of the business includes intangible assets in excess of $500,000 and the equity contribution from
the borrower and the seller combined is less than 25% of the
purchase price of the business, the application may not be
processed using delegated authority and must be sent to the
LGPC.
Pg 123 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
27
Equity Injection 101
5. The “purchase price of the business” includes all assets being acquired such as real estate, machinery and equipment,
and intangible assets. Real estate may not be removed from
the transaction and financed separately to avoid the 25% equity injection requirement for PLP processing.
6. The value of the intangible assets is determined by either
the book value as reflected on the business’s balance sheet, a
separate appraisal for the particular asset, or the value of the
business as identified in the business valuation minus the sum
of the working capital assets and the fixed assets being purchased.
7. If any of the loan proceeds will be used to finance intangible
assets, the amount must be specifically identified in the Use of
Proceeds section of the application and the Authorization.
Pg 123 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
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Equity Injection 101
Loans Less than $350,000
Lender must determine if the equity and the pro-forma debtto-worth are acceptable based on its policies and procedures
for its similarly-sized, non-SBA guaranteed commercial loans.
If the lender requires an equity injection and, as part of its
policies and procedures for its similarly-sized, non-SBA guaranteed commercial loans verifies the equity injection, it must
do so for SBA loans.
Pg 163 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
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Equity Injection 101
Equity Requirement for loans in excess of $350,000
Amount of Equity
Adequate equity is important to ensure the long term survival
of a business. The lender must determine if the equity and the
pro forma debt-to-worth are acceptable based on the factors
related to that type of business, experience of the management and the level of competition in the market area. The
lender must include in its credit analysis a detailed discussion
of the required equity and its adequacy.
30
Pg 166 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
Equity Injection 101
Equity Requirement for loans in excess of $350,000
Source of Equity Injection
The following may be considered as Equity Injection:
1. Cash that is NOT borrowed
2. Cash that IS borrowed only under the limited circumstances
outlined on the next slide:
31
Pg 166 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
Equity Injection 101
Equity Requirement for loans in excess of $350,000
2. Cash that IS borrowed
–
(a) SBA considers funds borrowed through the use of personal credit
for injection into the business as additional debt, not equity, with
one exception.
–
(b) If the Small Business Applicant can demonstrate repayment of
this personal loan from sources other than the cash flow of the
business, the cash injection may be considered equity. (Note: The
salary of the business owner does not qualify.)
–
(c) A lender must disclose any loan made to an individual for the
purpose of providing an equity injection into the business. The
lender’s credit analysis must address the impact on the personal
and business balance sheets and sources of repayment for such
side loans. If the SBA participating lender is providing the personal loan, the lender must submit the application for guaranty
through standard 7(a) processing.
Pg 167 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
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Equity Injection 101
Equity Requirement for loans in excess of $350,000
3. Assets other than Cash
Lenders must carefully evaluate the value of assets other than
cash that are injected by owners or principals. Therefore, an
appraisal or other valuation by an independent third party is
required if the valuation of the fixed assets is greater than the
depreciated value (net book value). A valuation of the fixed
assets provided as part of a business valuation will not meet
these requirements, except as part of a going concern appraisal as described in paragraph II.C.5.e) below.
Pg 167 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
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Equity Injection 101
Equity Requirement for loans in excess of $350,000
4. Standby debt
Debt that is on full standby (no payments of principal or interest for the term of the SBA-guaranteed loan) may be considered acceptable equity for SBA’s purposes. A debt that is on
partial standby (interest payments only being made) may be
considered equity when there is adequate historical business
cash flow available to make the payments. A copy of the note
must be attached to the standby agreement. (See Chapter 5,
Paragraph IV of this Subpart for additional discussion of
standby agreements.)
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Pg 167 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
Equity Injection 101
The following may not be considered as Equity Injection:
1. Value or cost of education; and
2. Funds that are borrowed and do not meet the exception
noted in subparagraph a)(2) above.
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Pg 167 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
Overview
●
Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
504 Rule
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
36
Documenting Equity Injection
●
Lenders must verify the injection prior to disbursing loan
proceeds and must maintain evidence of such verification in
their loan files.
●
Lenders are expected to use reasonable and prudent efforts
to verify that equity is injected and used as intended, and
failure to do so may warrant a repair or partial/full denial.
●
Lenders must submit with each purchase request on a loan
for which the loan authorization required an equity injection,
documentation to show that they verified the equity injection.
37
Pg 167 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
Documenting Equity Injection
Verifying a cash injection requires the following
documentation:
●
A copy of a check or wire transfer along with evidence that the check or
wire was processed showing the funds were moved into the borrower’s
account or escrow;
●
A copy of the statements of account for the account from which the
funds are being withdrawn for each of the two most recent months prior
to disbursement showing that the funds were available; and
●
A subsequent statement of the borrower’s account showing that the
funds were deposited or a copy of an escrow settlement statement
showing the use of the cash.
●
A promissory note, “gift letter” or financial statement is not sufficient evidence of cash injection without corroborating evidence consistent with
paragraph a) above.
38
Pg 168 SBA SOP 50 10 5(F) Effective Date: January 1, 2014
Documenting Equity Injection
Evidencing Equity Line of Credit
If the funds are being injected from the use of their personal credit the borrower must demonstrate repayment of this personal loan from sources other than the cash flow of the business, the cash injection is considered equity.
1. The settlement sheet/HUD from the closing of a personal loan can be used to verify the source of the injection. 2. Copy of HELOC Note 3. If the funds are being deposited into the business account prior to closing ‐ A copy of the statement from the account (or accounts) to which the equity injection funds were deposited and copy of the closing settlement statement showing the equity injection funds were injected/used.
*If the loan is approved under delegated authority be sure to include sufficient justification and comments in regard to the borrower’s personal ability to repay.
banc‐serv PARTNERS, September 2013
39
Documenting Equity Injection
Evidencing Standby debt
Debt that is on full standby (no payments of principal or interest for the term of the SBA‐guaranteed loan) may be considered acceptable equity for SBA’s purposes. 1. A copy of the note (complying terms should be verified) must be attached to the executed Standby Agreement form 155.
2. Standby Creditor must subordinate any lien rights in collateral securing the Loan to lender’s rights in the collateral, and take no action against Borrower or any collateral securing the Standby Debt without lender’s consent. banc‐serv PARTNERS, September 2013
40
Documenting Equity Injection
Evidencing Cash used for business purposes
Cash that was used for business purposes prior to loan disbursement. 1. A copy of the bank statements from the account which the funds were spent dated along with corresponding evidence such as; Copies of cleared checks or wire transfers with corresponding invoices evidencing use of cash or detailed receipts showing cash payments for business purchases (hand written receipts are not sufficient‐ must be formal PD IN FULL invoice).
banc‐serv PARTNERS, September 2013
41
Documenting Equity Injection
Evidencing Cash used for business purposes using Credit Cards
1. A copy of a the statements from the account which the funds were used to pay the credit card bill for each of the three most recent months showing the funds were available and spent.
2. A copy of a the credit card statements reflecting the purchases and payments made along with any subsequent statements needed to show the amount evidenced has been paid by the borrower. Statements should not reflect a balance after payment.
banc‐serv PARTNERS, September 2013
42
Overview
●
Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
44
Common Mistakes and Errors
●
Not collecting all documentation evidencing Equity Injection prior to loan disbursement.
●
Not fully evidencing Equity Injection prior to disbursement. (Disbursing the loan before all injection has been acquired.) HUGE NO!
●
Out dated bank statements. Bank statements are typically collected prior to or during the application process. If the loan doesn’t close with in the anticipated time frame then new statements should be collected and reviewed for accuracy.
●
Credit card statements that carry a balance and that haven’t been paid in full. (It is difficult to evidence which purchases remain unpaid if the statement isn’t paid in full.)
45
banc‐serv PARTNERS, September 2013
Common Mistakes and Errors
●
Often checks, receipts and bank statements do not collaborate. (Dates don’t match or account numbers.) (Equity Injection may originate from different accounts.)
●
In some cases the giver of the gift may be hesitant to provide the origination of their gift. (This must be enforced.)
●
Invoices are not provided with a corresponding cleared check or evidence of payment.
●
Hand made receipts or no receipts at all.
●
Failure to provide a Note. (HELOC or Standby)
banc‐serv PARTNERS, September 2013
46
Common Mistakes and Errors
●
Failure to prove repayment ability for a personal loan. (HELOC)
●
No evidence of the Equity Injection at the time of Closing. (The HUD or Settlement sheet didn’t evidence the Equity coming in or going out.)
●
Disbursement was made directly to the borrower. E.g. cash injection for working capital.
●
Failure to evidence other assets value or failure to provide evidence of asset injection.
●
These are just a few examples of the most common mistakes that we come across. If in doubt. Don’t disburse!
47
banc‐serv PARTNERS, September 2013
Overview
●
Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
48
Developing Best Practices
●
Lenders are responsible for complying with SBA requirements to keep the SBA guaranty in force, and the Authorization emphasizes this SBA policy.
49
banc‐serv PARTNERS, September 2013
Developing Best Practices
●
If there was an Early Default on the loan, documentation verifying that any equity injection required by the Loan Authorization was not only made, but that it came from a proper source, must be included in the Lender's Purchase Package. (See early default clarification)
50
banc‐serv PARTNERS, September 2013
Developing Best Practices
●
The Lender's failure to verify and properly document a material portion of an injection 0f cash or non‐cash assets required by the Loan Authorization raises a rebuttable presumption that the Early Default was caused by the lack of the injection and a full Denial of Liability is justified. 51
banc‐serv PARTNERS, September 2013
Overview
●
Equity Injection Fraud
●
Setting Borrower Equity Requirements
●
Equity Injection 101
●
Documenting Equity Injection
●
Common Mistakes & Errors
●
Best Practices
52
Questions?
By Bob Coleman
Editor, Coleman Report
[email protected]
53