Need To Establish Adequate Criteria for Evaluating the Eligibility of Loan Applicants Whose Principals Have Substantial Resources or Credit

Published by the Government Accountability Office on 1971-02-18.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                                 WASHINGTON, D.C.   20548

CIVIL DIVISION                                                                  1971

             Dear Mr. Kleppe:

                  The General Accounting Office examined into the Snall Business
             Administration's (SBA) evaluation and review of applicants' eligi-
             bility for business loans requested by firms whose owners have a
             large amount of personal resources and a high net worth. Our survey
             was conducted at the Washington, D.C., headquarters office of SBA,
             and the Boston and Denver Regional Offices.

                  Under section 7(a) of the Small Business Act (15 U.S.C. 636),
             SBA cannot extend financial assistance to a small business concern
             unless the assistance is not otherwise 'available on reasonable terms.
             SBA's National Directive 510-IA specifies that financial assistance
             will not be granted if the requested funds are obtainable, without
             undue hardship, through utilization of the personal credit or resources
             of the owners, partners, management or principal stockholders of the
             applicant. The directive further provides that to prevent the violation
             of the statutory restriction against making loans when personal resources
             or credit are otherwise available, the applicant must provide, for SBA's
             evaluation, adequate documentation of undue hardship.

                  Our survey revealed that SEA is providing or guaranteeing part of
             the financing for amounts greater than necessary because loan specialists
             were not adequately considering the personal resources or credit of the
             owners, partners, management or principal stockholders of the applicants
             in their analyses of loan applications. We believe criteria should be
             established which would specify to loan specialists when a loan should
             be disapproved or SBA participation reduced because the personal re-
             sources or credit of the principals are substantial enough to be used
             without undue hardship of the principals.
                  We reviewed section 7(a) business loans made by the Boston and
             Denver Regional Offices to applicants whose principals had an outside
             net worth of $50,000 or more. We made our selection from the 132 loans
             approved by the Boston Regional Office between July 1, 1969, and
             January 31, 1970, and from the 137 loans approved by the Denver Regional

Office between July 1, 1969, and December 31, 1969. Outside net worth
of a principal does not include his equity in the business which applies
to SB, for a loan.

     We identified 68 loans that were made to applicants of which one
or more principals bad an outside net worth of $50,000 or more. Our
review of these loans revealed that loan specialists were not giving
adequate consideration as to whether the principal's outside net worth
was sufficient to allow the principal to obtain all the financing with-
out SBa's financial assistance or to permit SBA to reduce its participation
in the loan.   Gererally, the principals did not furnish documentation of
undue hardship for SBA evaluation, and loan files did not contain documes-
tation indicating that a determination had been made as to whether undue
hardship would result if the principals were required to provide the funds
from their own resources or were required to use such resources as col-
lateral in arranging for a personal loan through coaiercial sources. Loan
specialists in the Denver Regional Office gave greater consideration to
the possibility that principals' personal resources night be used than did
those in the Boston Regional Office.

     We believe that, of the 68 loans revieved, 6 loans totaling $674,000
(one immediate participation loan and 5 guaranteed loans) should not have
been approved by SBA and 13 loans totaling $1,408,500 (two immediate
participation loans and 11 guaranteed loans) should have been approved
for lower amounts. Our conclusions on the 19 loans are based on one or
more of the following;

     (1)   Principal(s) had large amounts of liquid assets in
           relation to the loan.

     (2)   Principal(s) had large equity in businesses other than
           in the business which applied for the loan.

     (3) Principal(s) had high-value, mortgage-free residence
         or summer home.

      For example, the Denver Regional Office approved an tmnediate
participation loan of $66,000 whereby SBA was to finance 75 percent of
the loan amount; a bank was to finance the remainder. One principal
(40-percent stockholder) had investments in the business of $2.2 million
but also had an outside net worth of $543,000, including $77,302 in cash
and $362,283 in stocks and bonds.   In addition, the business had out-
standing two other SBA irediate participation loans totaling $513,371
in which SBA's share was $290,601.

     Interviews with SBA loan specialists confirmed that little or no
consideration was given to determining whether the principals' personal
resources or credit could be utilized without undue hardship.

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      Loan specialists advised us that in businesses with more than one
owner, it would be inequitable to require the principal with high out-
side net worth to make additional investments in the business when the
other principals may not be financially able to do likewise. We were
advised that there are no guidelines or directives concerning the
action to be taken in this type of situation.

     Also, the loan applications in question were those referred to
SBA by banks which requested SBA participation (generally a loan
guarantee).  We found that the SBA loan specialists approved SBA par-
ticipation in the loans with little consideration of the principals'
personal resources or credit because (1) the request by the bank implied
that the applied for funds were not otherwise available on reasonable
terms, and (2) SBA is heavily dependent on the banking industry for
the success of its lending programs mad it appears that loan specialists
may be overly concerned that reducing or disapproving the loan would
alienate the banks.

     We recognise SBA's dependence on the banking industry for the
success of its lending programs and appreciate the concern expressed
by the loan specialists. Such concern, however, should not lead SBA
to extend financial assistance to businesses when such assistance 1s
otherwise available on reasonable terms.  We believe that loan applica-
tions referred to SBA by banks should be carefully evaluated and the
financial statements of the principals involved should be reviewed in
sufficient depth to ascertain whether personal resources could be used,
without undue hardship, in lieu of all or part of an SBA loan or

     For certain loan applications, we questioned SBA officials why
those principals of the applicants who held high-valued securities
could not have obtained additional funds for the business on the
basis of their personal resources.   The SEA officials indicated that
the principals might have experienced undue hardship if they would
have had to sell their securities at the time when prices in the stock
market were falling. ND510-1A provides that forced sale of assets
resulting in a considerable loss is considered undue hardship. However,
documentation was not provided to show that a considerable loss would
result if securities were sold. In lieu of selling the securities,
they might have been utilized as collateral in arranging for a personal
loan through commercial sources.

     With   regard to the use of non-liquid personal assets, the Chief,
Financial   Assistance Division, Boston Regional Office, stated that he
would not   suggest that an individual sell real estate in order to obtain
funds for   his business. We agree that SEA should not go so far as to

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disapprove an application because a principal will not sell such assets.
We believe, however, that if a principal has a large equity in another
business, residence, sumwer home or other fixed assets, SBA should not
approve the loan unless the principal can demonstrate that he is unable
to obtain the requested funds through a mortgage or loan secured by
such   8ssets.


     Loan specialists are not adequately considering the personal
resources of the owners, partners, management or principal stockholders
of the applicant in their aealyses of loan applications.  The lack of
criteria to assist loan specialists in determining what conditions or
factors constitute undue hardship has created a situation which provides
the processing loan specialists with a large judgantal area as to when
lending assistance should be disapproved or reduced because the personal
resources or credit of the principals are substantial enough to be used
without undue hardship to the principals.

     We recommend that SBA establish criteria to assist a loan
specialist in deciding whether an application for SBA assistance should
be disapproved or modified, on the basis that the personal resources or
credit of the applicant's principals are substantial enough and that
additional financial assistance can be obtained elsewtiere without undue
hardship to the principals. W further recommend that when a loan
specialist has determined that undue hardship would result if a princi-
pal's personal resources or credit were utilized, the basis for such
a determination be adequately documented in accordance with existing
SBA policy.


      To preclude SBA from making loans to members of organized crime
and other persons not of good character, $BA national directives require
that Statements of Personal History (SBA Form 912) be submitted by the
applicant for certain principals and officials of the concern. Loan
officers are required to forward these forms to the Office of Security
and Investigation for its review.   Twenty-one of the 68 loan files
reviewed did not contain the required Statements of Personal History.

     Our review of the 68 loans showed that, based on available
information, none of the loans were made to businesses whose principals
or officials were knownra to be metbers of organized crime.   We believe,
however,   that the Statements of Personal History should be included in
all loan files as required.

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     We recoumInd that   propriate follow-up be made to ensure that
the statements are subaitted and reviewed before loan applications
are approved.

     We appreciate the cooperation extended to our representatives
during the survey, and we will be pleased to discses our report with
you or your representatives if you so desire. Ws plan no further
reporting on the imttera discussed in the report at this tila; however,
we vould appreciate your coamnts on the action taken or contemplated
on our recommendations.

                                    Sincerely yours,

                                    Associat   Director

The Honorable Thoms S;i Kleppe
  aintmaitrator, Small Bustness

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