**MEMORANDUM FROM**

**USDA, Rural Development**

###### Business and Industry Division, GA

> **Business and Industry (B&I) Guaranteed Loans**

######## February 21, 2003

**We, at Rural Development in Georgia, are certainly supportive of any
proposal that can be documented to meet and/or exceed our current
policies and established guidelines. It is not the intent of the
guarantee authority to be used for marginal or substandard loans or for
the relief of lenders having such loans.**

**Recently, a team of seven Business Programs Directors and Loan
Specialists reviewed 71 loan files from across the nation on loans for
which final losses were paid or were repurchased; based on this review,
the following concerns were expressed:**

**Concern: Poor management or management decision-making by the agency,
lender and borrower was the prevalent problem with these loans.**

**Recommendation: The lender's assessment of the Business management
history will have to be documented in the application process. Loan
purposes must be consistent with the general purpose of guaranteeing
"quality" loans, which will provide "lasting" community benefits.
Previous success ordinarily is a good indicator of the potential for
future success. While refinancing outstanding debt is still a
"conditioned" eligible purpose, our State Loan Review Board (SLRB) has
determined that the maximum allowable percentage of guarantee will be
reduced by a minimum of 10 percent, if refinancing is a "primary" part
(more than 50%) of the overall loan proposal.**

**Concern: In many cases, equity was either insufficient or
miscalculated.**

**Recommendation: You should consult RD AN No. 3752 dated April 10,
2002, for guidance on the calculation of tangible balance sheet equity.
The lender may require additional equity other than the minimums
contained in RD Instruction 4279-B, section 4279.131(d), for riskier
loans such as startups, recreation, tourism projects, energy related
businesses, biomass projects, and loans without "unconditional" personal
and/or corporate guarantees. You should consult RD AN No. 3801, dated
November 14, 2002, for guidance and clarification concerning the
Administrator's directives relative to obtaining unconditional personal
and/or corporate guarantees. All future loan guarantee agreements are to
require an "unconditional" personal and/or corporate guarantee. A
guarantee of payment is not equivalent to a full, unconditional personal
or corporate guarantee, because it is restricted in coverage to limited
situations.**

**Concern: Weakness in or the lack of feasibility studies and/or
business plans was another frequent problem.**

**Recommendation: Our SLRB has determined that feasibility studies are
required for all startup businesses and for existing businesses with
projected significant change in operations. RD Instruction 4279-B,
Appendix A, provides the content of an acceptable feasibility study.**

**Concern: Optimistic projections were the next most frequent problem.**

**Recommendation: RD Instruction 4279-B, section 4279.131(a), states:
"All efforts will be made to structure or restructure debt so that the
business has adequate debt coverage and the ability to accommodate
expansion." The ability to repay the loan from business cash flow is the
most important consideration in the decision to approve or deny a loan.
You should review historical operations of existing businesses to see if
historical cash flow would have been adequate to service the proposed
debt. Many times projections will even exceed industry averages. In
those cases, projections should be scaled-back in line with industry
averages, and repayment ability should be tested against those
scaled-back projections.**

**Concern: There was evidence of previous historic losses with the
business, its principals, and its affiliates in some cases.**

**Recommendation: Again, historic operations are the best basis to
evaluate cash flow. Businesses that have poor historic earnings are not
likely to turn around without substantial changes in operating
procedures. Something dramatic must occur for the business to succeed
after a history of losses or substandard earnings.**

**Concern: The lack of working capital was a significant concern.**

**Recommendation: Adequate working capital is critical to the success of
the business. By definition, working capital measures a business'
ability to meet its short-term obligations. Working capital is the
balance of current assets minus current liabilities. Do not confuse the
terms working capital and operating capital. You should use the
following formula to calculate working capital needs.**

####### Working Capital Needs

1.  **Cost of Goods Sold (COGS) percentage times Inventory Turnover (in
    days).**

2.  **Result in step 1 plus Accounts Receivable Turnover (in days).**

3.  **COGS percentage times Accounts Payable Turnover (in days).**

4.  **Result in step 2 minus result in step 3.**

5.  **Sales/365.**

6.  **Result in step 5 times result in step 4.**

**Total the results for each step and add them together. For the COGS
percentage and turnover, use Risk Management Association (RMA) median
averages. You can also use the COGS percentage and turnovers based on
the projections of the applicant to calculate working capital needs as
well. Compare the two figures to see if the projections are in line with
industry averages. This should help determine if the projections provide
for enough working capital.**

**Concern: Poor financial information was another serious concern that
surfaced.**

**Recommendation: RD Instruction 4279-B, sections 4279.161(a)(3) and
4279.161(b)(8), contain the financial information required with a
complete application. Projections must be reviewed as previously stated;
therefore, you should consult RD AN No. 3757 dated May 1, 2002, relative
to specific lender financial analysis requirements related to loan
processing and servicing. We suggest that all lenders and applicants
download and use the B&I Loanpack 2000 program when submitting a B&I
loan application. This can be downloaded from the following web site:**

> [**http://www.rurdev.usda.gov/rbs/pub/softw/biloanpack.htm**](http://www.rurdev.usda.gov/rbs/pub/softw/biloanpack.htm)

**Concern: Cost or time overruns were contributing factors to failure of
some of the loans reviewed.**

**Recommendation: RD Instruction 4279-B, section 4279.156(a) states:
"The lender must ensure that all project facilities must be designed
utilizing accepted architectural and engineering practices and must
conform to applicable Federal, state, and local codes and requirements.
The lender will also ensure that the project will be completed with
available funds and, once completed, will be used for its intended
purpose and produce products in the quality and quantity proposed in the
completed application approved by the Agency." It is recommended that
one of the conditions of the Conditional Commitment place the
responsibility for cost overruns on the borrower. However, there have
been occasions where we have financed the cost overruns with a
subsequent loan.**

**Often when the Agency is requested to guarantee cost overruns; we are
faced with the decision of whether to enforce the condition at the
expense of the entire project. If it appears that the borrower is unable
to complete the project from its own financial resources, consideration
will be given to reducing the percentage of guarantee for the loan for
cost overruns. Section 4279.156(b) states: "The lender will monitor the
progress of construction and undertake the reviews and inspections
necessary to ensure that construction conforms with applicable Federal,
state, and local code requirements; proceeds are used in accordance with
the approved plans, specifications, and contract documents; and that
funds are used for eligible project costs." The lender is fully
responsible for construction monitoring. Please be aware that our SLRB
has determined that the Loan Note Guarantee (LNG) will not be issued up
front, but only when the construction is primarily complete and the
facility is ready for operation.**

**Although RD Instruction 4279-B, section 4279.131, states that the
lender is primarily responsible for determining credit quality, the
Agency must adequately review the lender's analysis. Additionally, the
Agency has the responsibility for determining if the lender's
underwriting of the loan is consistent with sound practices.**

**Concern: Weak appraisals are an issue of concern.**

**Recommendation: Appraisals made at loan closing were compared to
market and liquidation values 1 year later or less and were found to be
valued much lower at the time of liquidation (in some instances, the
market value was 75-80 percent less than market value at loan closing).
Substantial variances in the value of real estate or machinery and
equipment require a detailed explanation from the appraiser as well as
the lender. Under no circumstances should you accept an appraisal from
the borrower. Only those appraisals delivered by the appraiser directly
to the lender should be accepted. You should consult RD AN No. 3798
dated October 22, 2002, for guidance relative to lender responsibilities
for acceptable real property and chattel appraisals. Our Unnumbered
Letter entitled, "B&I Guaranteed Loan Program Appraisals and Appraisal
Review Checklist," dated November 14, 2002, is intended to help ensure
that appraisals meet Standards I and II of the Uniform Standards of
Professional Appraisal Practices (USPAP) and provides the lender with a
mechanism for completing administrative reviews of all real property
appraisals for the B&I guaranteed loan program.**

**The team noted a few cases where fraud was suspected with no action
taken. In the event, we have serious suspicions and/or proof about a
borrower or lender's activities, the Office of Inspector General will be
requested to conduct an investigation or an audit.**

**You should pay close attention to the concerns raised in this letter.
Future reviews of post-review material and file reviews of B&I loans for
Business Programs Assessment Reviews will target these concerns to
ensure they are satisfactorily addressed.**

**We look forward to systematically processing your request and others
in Georgia. This will require a mutual understanding of what is expected
from all parties the applicant, bank, and Rural Development. This will
require keeping lines of communications open and "being open and up
front with all parties." With teamwork and all players working
cooperatively we will build the B&I Program with quality loans that will
provide lasting community benefits. Providing timely service to
customers based on the established guidelines is a priority that we will
all strive to follow.**

**Situations that clearly do not meet established guidelines or policies
will result in unfavorable determinations and adverse actions; however,
each loan proposal will be evaluated on a case-by-case basis when
determining the appropriate Agency response.**

**Again, thanks for your interest in Georgia's B&I program and should
you have any questions call me at 706-546-2154 or email:**
<eddie.douglas@ga.usda.gov>

**Eddie M. Douglas**

**Rural Business Specialist**

**USDA, Rural Development**