The Winds of Change are Blowing: The SBA’s Move to Expand Access to Capital and Promote Efficiency in Small Business Lending
By James R. White, Executive Vice President and General Counsel of Gulf Coast SBA Lending in Raleigh, North Carolina
When thinking about government guaranteed lending programs, I find it is helpful to think of it as participation. More specifically, a participation where the federal government and/or its respective agencies (herein “Government”) are participating with my lender client to make a loan to a borrower under the relevant government guaranteed loan program. In this “participation”, the government makes the rules that my lender client must follow in order to ensure the Government’s participation. Possible consequences of my lender client’s failure to adhere to the Government’s rules are either a repair (partial denial of the Government’s guaranty) or a full denial of the subject guaranty.
One can quickly surmise, that knowledge and compliance with the rules governing the relevant loan program is vital. Further, government guaranteed lending policies, rules and regulations are not static. One example is the Small Business Administration’s (“SBA”) 7(a) loan program, which has seen significant program changes within the past year.
By way of background, the SBA has for years been searching for ways to expand access to capital for underserved communities. To accomplish this goal, the SBA issued the following two Final Rules amending loan program regulations:
SBA’s Final Rule on Affiliation and Lending Criteria for the SBA Business Loan Programs (88 FR 21074, effective May 11, 2023) (Rule) (herein “First Final Rule”)
SBA’s Final Rule on Small Business Lending Company (SBLC) Moratorium Rescission and Removal of the Requirement for a Loan Authorization (88 FR 21890, effective May 12, 2023) (Rule) (herein “Second Final Rule”)
Further, the SBA issued several implementing Procedural Notices, a revised Standard Operating Procedure (“SOP”) governing the SBA’s loan origination policies and procedures (SOP 50 10 7), a second revised SOP governing the SBA’s loan origination policies and procedures (SOP 50 10 7.1), and a revised servicing SOP (50 57 3). Through these various mechanisms, the SBA implemented several significant changes to its 7(a) loan program. These changes are designed to expand access to capital for small businesses and streamline various aspects of the loan application and approval process.
Below is an overview of three key changes to the SBA’s 7(a) program origination policies and procedures:
AFFILIATION
13 CFR § 121.301 states,
The Small Business Act defines a small business concern as one which is independently owned and operated, and which is not dominant in its field of operation. SBA interprets this statutory definition to require, in certain circumstances, the inclusion of other entities (“Affiliates”) owned by the Applicant or an owner of the Applicant in determining the size of the Applicant.
As it relates to the 7(a) loan program, the SOP provides the Applicant, including affiliates, must meet SBA requirements in order to be eligible under the loan program. Therefore, it is imperative that lenders accurately identify all affiliates of the potential borrower.
Under the SBA’s SOP governing SBA’s loan origination policies and procedures in effect just prior to the above referenced changes, SOP 50 10 6, affiliation was determined as follows:
- a. Affiliation exists when:
- i. One individual or entity controls or has the power to control another; or
- ii. a third party or parties controls or has the power to control both.
- b. SBA considers factors such as ownership, management, identity of interest between close relatives, newly organized concerns, and franchise, license or other agreements/relationships when determining whether affiliation exists. See 13 CFR 121.03 and 121.301(f ) for SBA’s requirements related to the determination of affiliation for the business loan programs.
In an effort to simplify the affiliation determination, the SBA removed the concept of control, noting its reasoning in the First Final Rule as follows:
…the concept of control as it exists requires understanding and expert consideration of business entity relationships well beyond what is owned by the applicant business or its owners. These considerations are complex and require judgement calls that confuse and unnecessarily burden small business applicants and lenders, and ultimately result in inconsistent application of this concept.
Correspondingly, the new affiliation determination rule is a simple series of tests as follows:
- Does the Applicant own more than 50 percent of another business? If so, the Applicant and the other business are affiliated.
- Does a business own more than 50 percent of an Applicant? If so, then the business that owns the Applicant is an affiliate of the Applicant.
- Does the business owner that owns more than 50 percent of the Applicant own more than 50 percent of another business that operates in the same 3-digit NAICS subsector as the Applicant? If so, then the business entity owner, the other business and the Applicant are all affiliated.
- Does an individual own more than 50 percent of the Applicant and more than 50 percent of another business entity that operates in the same 3-digit NAICS subsector as the Applicant? If so, the Applicant and the individual owner’s other business entity are affiliated.
- If there are no owners that singly own more than 50 percent of the Applicant, does another entity own 20% or more of the Applicant and operate in the same 3-digit NAICS subsector as the Applicant? If so, then the Applicant and that owner are affiliated.
- If there are no owners that individually own more than 50 percent of the Applicant, does another owner of 20% or more of the Applicant also own more than 50% of another business entity that operates in the same 3-digit NAICS subsector as the Applicant? If so, the Applicant and the owner’s other business are affiliated.
In addition, there are a couple of important rules to keep in mind these rules are applied. First, ownership interest of spouses and minor children must be combined when considering ownership percentages. Second, the SBA does consider the pro rata ownership of entities when determining the percentage of ownership that an individual owns in an Applicant. Finally, for purposes of ownership determination, SBA considers stock options and convertible securities as though the rights granted thereunder have been exercised.
PARTIAL CHANGE OF OWNERSHIP
Prior to the recent changes, only under certain limited circumstances could loan proceeds made through the 7(a) program be used to fund acquisition of partial changes of ownership. With the rule changes, SBA Loan proceeds may now be used to fund partial changes of ownership. Specifically, the First Final Rule amends 13 CFR 120.202, which now states:
A Borrower may use 7(a) loan proceeds to purchase a portion of or
the entirety of an owner’s interest in a business, or a portion of or the entirety of a business itself. 13 CRF 120.202
Further, the SBA has a longstanding rule that prohibits loan proceeds being used to make payments to an associate of the Applicant (defined, in part, as a 20% or more owner). The SBA altered that rule to allow payments to an associate in the context of a partial change of owners. The relevant section of SBA SOP 50 10 7.1 now includes a carve out as follows:
Loan proceeds may not be used for any of the following purposes (including the replacement of funds used or borrowed for any such purpose):
- Payments, distributions, or loans to an Associate of the Applicant (as defined in 13 CFR § 120.10), except for compensation for services actually rendered at a fair and reasonable rate or to facilitate 7(a) loans for changes of ownership in accordance with § 120.202 and the guidance in Section B of this SOP on partial changes of ownership; (emphasis added)
The shift to allow loan proceeds to be used for partial changes of ownership is a major policy shift by the SBA and according to the First Final Rule designed to “expand pathways to ownership”.
Further, the SBA states in the First Final Rule:
The revision will allow a borrower to purchase a portion of the business or a portion of an owner’s interest in a business, or to purchase the entire business or an owner’s entire interest. A borrower could also purchase the partial or entire interests of multiple owners. This revision will allow borrowers to use 7(a) loan proceeds to fund partial changes of ownership and will help provide employees a path to ownership.
AUTHORIZATION ELIMINATION
Prior to the recent rule changes, the SBA required a written agreement between the SBA and the Lender known as the SBA Loan Authorization (“Authorization”) for each loan made under the 7(a) program. The Authorization provided detailed terms and conditions that must be met in order for the SBA to guarantee the specific loan.
The Authorization was generated in accordance the National Authorization Boilerplate, which provided the conditions for the loans that reflected the SBA’s policies and procedures. It contained mandatory standard language to be used nationwide along with relevant state specific requirements. The party responsible for drafting the authorization was determined by how the loan was processed (by the lender if it was using delegated authority to make the loan or the SBA for non-delegated loans). Depending on the specifics of each loan, some Authorizations were quite lengthy.
In a continuation of its efforts to streamline the 7(a) program, the SBA eliminated the SBA Loan Authorization. The SBA noted in the Second Final Rule,
“SBA’s current policy of requiring a separate Loan Authorization document that contains the loan terms and conditions in addition to the loan terms and conditions that the SBA Lender also submits to SBA with its guaranty application is cumbersome, outdated, and duplicative. SBA is revising its regulations to eliminate the duplication of effort and opportunity for a mismatch of information between multiple sources of the loan terms and conditions.”
Further, the move by the SBA is an effort to make the 7(a) loan process more efficient. Now, the official source of all terms and conditions (including any modifications) under which SBA has agreed to provide a guaranty will be maintained in SBA’s E-Tran system, which is the system that generates the loan number. Lenders now input the individual loan terms and conditions into E-Tran and once completed generate a document known as the SBA Terms and Conditions through the E-Tran system. The SBA Terms and Conditions requirements are borne out in SOP 50 10 7.1 which states,
“The E-Tran loan guaranty authorization request is the digital request by the Lender to SBA to authorize the Lender to make the loan with an SBA guaranty under the terms and conditions submitted in E-Tran. SBA’s guaranty is subject to the terms and conditions authorized by SBA in E-Tran (including any changes) and the Lender’s compliance with those terms and conditions and all other applicable SBA Loan Program Requirements.”
A complete discussion of the exhaustive changes to the 7(a) program is outside the scope of this article. However, these three changes are indicative of the SBA’s efforts to modernize its programs and make them more accessible and user friendly for small businesses, thereby addressing capital access gaps and fostering growth in various business sectors. The updated guidelines are expected to empower entrepreneurs to pursue business acquisitions and expansions more confidently.
This article originally appeared in The Abstract – Spring 2024 (American College of Mortgage Attorneys) and is shared here courtesy of the author.