u.s. SMALL BUSINESsAoMINISTRATION 

OFFICE OF INSPECTOR GENERAL 

ADVISORY MEMORANDUM 

Report NUMBER 13-16R 

DATE: June 14, 2013 

TO: John A. Miller, Director, Office of Financial Program Operations 

SUBJECT: Purchase Reviews Allowed $4.6 Million in Improper Payments on 7(a) Recovery Act 

Loans 

This advisory memorandum is the first in a series of memorandums resulting from our ongoing audit 

of purchased 7(a) Recovery Ace loans. The purpose of this memorandum is to notify you of improper 

payments 2 made on six loans and to recommend recovery of the related questioned costs. 3 

These improper payments were the result of lender deficiencies that went undetected during SBA's 

purchase reviews. The total approved amount for these loans was approximately $6.7 million, and the 

SBA purchased its guaranteed share of the principal loan balances for approximately $4.6 million. 

The objective of the ongoing audit is to determine if the SBA is mitigating its risk of loss. Specifically, 

whether the SBA is ensuring that 7(a) Recovery Act loans were originated, closed, liquidated, and 

purchased in accordance with SBA's policies and procedures, and prudent lending standards. 

To accomplish our objective, we used a new, internally developed, risk-based sample selection 

methodology. The judgmental sample scoring system allocated rating points according to perceived 

risks. The perceived risks included time lapse between loan approval and its transfer to liquidation, loan 

amount, equity injection, loan packager involvement, and the use of proceeds. We obtained a universe 

of 105 loans that consisted of high-dollar early defaulted Recovery Act loans, which were purchased by 

the National Guaranty Purchase Center (NGPC) between February 17, 2009, and January 31,2012. 

Of the universe of 105 loans, we eliminated loans that were involved in previous audits or were in an 

unstable status due to review process or guaranty repair action. We then selected 20 loans that we were 

able to access from the NGPC. From those, we reviewed eight loans that were a part of the Preferred 

Lenders Program (PLP). We determined the risk-based sample selection methodology to be highly 

effective at pinpointing loans with material deficiencies to enhance the impact of our audit. In fact, 

material deficiencies were identified in each of the first eight loans reviewed. We identified suspicious 

activity in two loans and referred them to the Office of Inspector General (OIG) Investigations Division. 

As a result, we omitted the details of the deficiencies on those two loans from this report. The remaining 

six reviewed loans resulted in questioned costs totaling $4.6 million. 

1 American Recovery and Reinvestment Act of 2009, Public Law 111-5. 

2 For the purpose of this memorandum, an improper payment is defined as any payment that should not have 

been made or that was made in an incorrect amount under statutory, contractual, administrative, or other legally 

applicable requirements 

3 For purposes of this memorandum, "questioned costs" are defined as costs questioned by the DIG, which were 

incurred as a result of material origination, closing, and purchase deficiencies made by lenders or the SBA. 

1 

To answer the objective, we reviewed all origination, closing, and purchase actions as documented in 

SBA and lender loan files. We also reviewed information in the SBA's Loan Accounting System for all 

loans examined. 

We conducted this audit between March 2012 and February 2013 in accordance with Generally 

Accepted Government Auditing Standards (GAGAS). Those standards require that we plan and perform 

the audit to obtain sufficient, appropriate evidence to provide a reasonable basis on our audit 

objectives. We believe that the evidence obtained provides a reasonable basis for our findings and 

conclusions based on our audit objective. To assess the internal controls relevant to our objective, we 

reviewed the SBA's policies and procedures regarding loan origination, closing and purchasing. 

In addition, we designed and distributed an internal control questionnaire survey to a random sample of 

representatives from the Office of Capital Access and the Office of Financial Program Operations. 

We analyzed the survey results to aid in our understanding of the internal controls relevant to our 

on-going audit of 7(a) Recovery Act loans. 

BACKGROUND 

The Recovery Act provided the SBA with $730 million to expand the Agency's lending and investment 

programs, create new programs to stimulate lending to small businesses, and conduct oversight of these 

programs. A portion of the $730 million funding was also used for eliminating fees and increasing the 

maximum loan guaranty to 90 percent for eligible 7(a) loans. Accordingly, we conducted this audit due to 

concerns that some lenders would not exercise due diligence in originating and closing loans given that 

the 90 percent SBA guaranty reduced lender risk. 

The SBA guarantees loans that are made by participating lenders under a Guaranty Agreement to 

originate, service, and liquidate loans in accordance with SBA loan program requirements (which 

include, among other things, SBA regulations, standard operating procedures, and other directives). 

When a borrower defaults on such a loan, the lender can request payment of the guaranty. Prior to 

paying the guaranty (which the SBA refers to as IIpurchasing" a guaranty), the SBA reviews loan 

documentation to evaluate the lender's compliance with program rules and regulations and 

commercially prudent lending standards. This review is SBA's primary control for ensuring lender 

compliance and preventing improper payments. In the event of noncompliance, the SBA may be 

released from its liability on a loan guaranty, in full or in part if the lender has failed to comply 

materially with any Loan Program Requirement for 7(a) loans. Previous OIG audits have identified 

material lender noncompliance in loan origination, closing, and liquidation that were not detected in 

SBA's purchase review processes, resulting in improper payments. 

RESULTS 

The audit found that six 7(a) Recovery Act Loans were not originated and closed in accordance with 

SBA's rules and regulations including Standard Operating Procedure (SOP) 50 10 and the Code of 

Federal Regulations4 (CFR). As the deficiencies identified in the six loans were not detected during 

SBA's purchase reviews, they resulted in inappropriate or unsupported disbursements of approximately 

$4.6 million, which are further detailed in the Appendices of this report. The deficiencies and the related 

requirements are summarized in Table 1, and include: 

413 CFR 120. 

2 
Deficiency Type A: Questionable Eligibility 

According to SOP 50 10 5(B), the small business must meet the eligibility requirements at the 

time of application and, with the exception of the size standard, must continue to meet these 

requirements through the closing and disbursement of the loan. 

Deficiency Type 8: Inadequate assurance ofrepayment ability 

According to SOP 50 10 5(B), on SBA-guaranteed loans, the cash flow of the Small Business 

Applicant is the primary source of repayment. Thus, if the lender's financial analysis 

demonstrates that the Small Business Applicant lacks reasonable assurance of repayment in a 

timely manner from the cash flow of the business, the loan request must be declined. 

Deficiency Type C: Equity Injection Issues 

Adequate equity is important to ensure the long-term survival of a business. According to 

SOP 50 10 5(A), the lender must include in its credit analysis a detailed discussion of the 

required equity and its adequacy. The SOP also requires lenders to verify the source as well 

as the existence of an equity injection that is greater than 1/3 of the amount of the loan or 

$200,000, whichever is less. Examples of credible evidence to demonstrate an equity 

injection came from a source consistent with SBA Loan Program requirements are outlined in 

SOP 50 513. Credible evidence would include documentation showing that the injection 

(1) came from a legitimate source; (2) occurred prior to the initial loan disbursement; and 

(3) consisted of the required amount of cash or the required value of non-cash assets. 

Deficiency Type D: Insufficient collateral 

According to SOP 50 10 5(A), the SBA requires the lender to collateralize the loan to the 

maximum extent possible up to the loan amount. The SBA considers a loan as IIfully secured" if 

the lender has taken security interests in all available assets with a combined "liquidation value" 

up to the loan amount. 

Table 1 Summary of Findings 

loan 

Number 

Borrower's Name Deficiency 

Type 

Amount 

Approved 

SBA Guaranty 

Amount 

Questioned 

Costs 

[Ex. 4] [Ex. 4] A,B $ [Ex. 4] $1,485,000 $1,425,247 

[Ex. 4] [Ex. 4] A $ [Ex. 4] $900,000 $669,963 

[Ex. 4] [Ex. 4] B $ [Ex. 4] $1,180,000 $967,869 

[Ex. 4] [Ex. 4] A,B,C $[Ex.4] $675,000 $555,368 

[Ex. 4] [Ex. 4] A,B,C,D $ [Ex. 4] $1,125,000 $310,637 

[Ex. 4] [Ex. 4] C $[Ex. 4] $694,800 $680,900 

Total $6,742,000 $6,059,800 $4,609,984 . . .. .. Legend: A) Questionable Eligibility B) Inadequate Assurance of Repayment Ability C) Equity Injection Issues D) 

I nsufficient Collateral 

3 
The deficiencies, which went undetected by the National Guaranty Purchase Center (NGPC), were an 

indication of serious flaws in the NGPC's purchase process. However, we previously issued two audit 

reports and made recommendations to address the deficiencies in the purchase review process. 

Specifically, in March 2012, we issued Audit Report 12-11R, High-Dol/or Early-Defaulted Loans Require 

an Increased Degree ofScrutiny and Improved Quality Control at the National Guaranty Purchase Center. 

In that report, we identified that loan documentation was not reviewed with the level of scrutiny 

necessary to identify all material deficiencies on high-dollar early-defaulted loans. A subsequent 

report was issued by our office in August 2012, Audit Report 12-18, A Detailed Repayment Ability 

Analysis is Needed on High-Dol/or Early-Defaulted Loans to Prevent Future Improper Payments. In this 

audit, we found that the assessment of delegated lender underwriting performed at the NGPC on highdollar early defaulted loans was not effective in identifying whether lenders were clearly negligent in 

determining the borrowers' repayment ability. 

Both reports sought to improve the purchase review process. The critical recommendations included 

suggestions to: (1) expand the scope of the NGPC's quality control reviews of early-defaulted loans; 

(2) establish a specialized early default purchase review unit; (3) train NGPC purchase staff to perform 

effective analyses of lenders' repayment ability computations, and (4) revise its purchase process for 

high-dollar early-defaulted loans approved by lenders to verify compliance with SBA's repayment ability 

requirements. We will not be making similar recommendations in this report as the loans reviewed in 

this audit were purchased prior to the implementation of these previous recommendations. Future 

audits and additional loan reviews will assess the process after the implementation of our 

recommendations. 

CONCLUSIONS 

The audit found that lenders did not originate and close the six 7(a) Recovery Act loans in accordance 

with the SBA's loan program requirements. Furthermore, SBA loan officers did not identify the 

deficiencies in the six loans during their purchase reviews. The SBA purchased its guaranties on these 

six loans, which resulted in approximately $4.6 million of questioned costs. As a result of the identified 

deficiencies, we recommended that the SBA seek recovery of approximately $4.6 million. 

RECOMMENDATIONS 

We recommend that the Director, Office of Financial Program Operations: 

1. 	 Seek recovery of $1,425,247 from Compass Bank on the guaranty paid by the SBA for the 

loan to [Ex. 4] 

2. 	 Seek recovery of $669,963 from The Washington Trust Company on the guaranty paid by 

the SBA for the loan to [Ex. 4] 

3. 	 Seek recovery of $967,869 from High Trust Bank on the guaranty paid by the SBA for the 

loan to [Ex. 4] 

4. 	 Seek recovery of $555,368 from Monadnock Community Bank on the guaranty paid by the 

SBA for the loan to [Ex. 4] 

4 

5. 	 Seek recovery of $310,637 from Plaza Bank on the guaranty paid by the SBA for the loan 

to [Ex. 4] 

6. 	 Seek recovery of $680,900 from American Bank of Commerce on the guaranty paid by the 

SBA for the loan to [Ex. 4] 

AGENCY COMMENTS AND OFFICE OF THE INSPECTOR GENERAL RESPONSE 

On March 12, 2013, we provided a draft of this advisory memorandum to the Director, Office of Financial 

Program Operations (OFPO) for comment. On April 26, 2013, the Director submitted formal comments, 

which are included in their entirety in Appendix VII. The Director concurred with three 

recommendations to recover $1,535,968 on three loans. The Director, however, did not concur with the 

three remaining recommendations to recover a total of $3,074,016 in SBA guaranties on three other 

loans. The Director reported that the OFPO has continued its training of National Guaranty Purchase 

Center (NGPC) finance professionals processing guaranty purchases for high dollar early defaults. In 

addition, the OFPO has differentiated the standard given to NGPC staff so additional credit is given to 

support purchase reviews of early-defaulted, high-dollar loans. Finally, OFPO has initiated Risk 

Management initiatives at the NGPC, including tracking purchase deficiencies detected during quality 

control reviews and providing corrective action and education. A summary of management's comments 

and our response for each recommendation follow: 

Recommendation 1 - Seek recovery of $1,425,247 from Compass Bank on the guaranty paid by the SBA 

for the loan to [Ex. 4] 

Management Comments 

The Director did not concur with this recommendation based on the reasons provided by the OIG in its 

findings of questionable eligibility and inadequate assurance of repayment ability. However, he stated 

that the OFPO is reviewing an additional issue that the OIG did not identify, which may warrant full 

recovery from the lender. The Director agreed to report his findings to the OIG by June 15, 2013. 

OIG Response 

The Director's comments did not include an explanation for why he did not agree with the OIG's findings. 

Further, he did not provide the details of the additional issue that was identified for the OIG to consider 

and respond. This recommendation will be resolved during the audit follow-up and resolution process. 

Recommendation 2 - Seek recovery of $669,963 from The Washington Trust Company on the guaranty 

paid by the SBA for the loan to [Ex. 4] 

Management Comments 

The Director concurred with this recommendation and will request a full recovery of $669,963 from the 

lender by May 31, 2013. 

OIG Response 

We consider management's comments to be responsive to the recommendation. 

5 

Recommendation 3 - Seek recovery of $967,869 from High Trust Bank on the guaranty paid by the SBA 

for the loan to [Ex. 4] 

Management Comments 

The Director did not concur with this recommendation. However, he stated that the OFPO will enter this 

loan into the Office of Capital Access Headquarters denial review process no later than May 31, 2013. 

OIG Response 

The Director's comments did not provide a specific rationale for his non-concurrence. This 

recommendation will be resolved during the audit follow-up and resolution process. 

Recommendation 4 - Seek recovery of $555,368 from Monadnock Community Bank on the guaranty 

paid by the SBA for the loan to [Ex. 4] 

Management Comments 

The Director concurred with this recommendation and will request a full recovery of $555,368 from the 

lender no later than May 31, 2013. 

OIG Response 

We consider management's comments to be responsive to the recommendation. 

Recommendation 5 - Seek recovery of $310,637 from Plaza Bank on the guaranty paid by the SBA for 

the loan to [Ex. 4] 

Management Comments 

The Director concurred with this recommendation and will request a full recovery of $310,637 from the 

lender no later than May 31, 2013. 

OIG Response 

We consider management's comments to be responsive to the recommendation. 

Recommendation 6 - Seek recovery of $680,900 from American Bank of Commerce on the guaranty 

paid by the SBA for the loan to [Ex. 4] 

Management Comments 

The Director did not concur with this recommendation. He stated that the lender was contacted by the 

NGPC and provided additional supporting information. As a result, he believes all issues detailed in the 

subject finding have been resolved. This information will be provided to the OIG to satisfy this 

recommendation. 

6 
OIG Response 

The Director did not provide a specific explanation for how the additional supporting information 

resolved the GIG's finding of unsubstantiated equity injection. This recommendation will be resolved 

during the audit follow-up and resolution process. 

ACTIONS REQUIRED 

Please provide your management decision for each recommendation on the attached SBA Form 1824, 

Recommendation Action Sheet, within 30 days from the date of this report. Your decision should 

identify the specific action(s) taken or planned for each recommendation and the target date(s) for 

completion. 

We appreciate the courtesies and cooperation of the Small Business Administration during this audit. 

If you have any questions concerning this report, please call me at (202) 205-7390 or Terry Settle, 

Director, Credit Programs Group, at (703) 487-9940. 

*** 

/s/ 

John K. Needham 

Assistant Inspector General for Auditing 

7 

Appendix I: [Ex. 4] 

The deficiencies on this loan resulted in a $1,425,247 improper payment that should be recovered. 

The lender, Compass Bank, was authorized by the Small Business Administration (SBA) to make 

guaranteed loans under the Preferred Lenders Program (PLP). As a PLP lender, the bank was permitted 

to process, close, service, and liquidate loans with limited documentation and review by the SBA. 

The lender approved a $ [Ex. 4] Recovery Ace loan to the borrower with a 90 percent SBA guaranty 

on [Ex. 4] , 2009, for the purchase of all outstanding stock of a company and for the refinancing of 

debt. However, the lender did not properly verify that the transaction resulted in a 100 percent 

ownership by the buyer. The lender also did not properly analyze repayment ability based on historical 

financial statements and projections. The National Guaranty Purchase Center (NGPC) purchased the 

loan on August 5, 2011, for $1,425,247. The loan should not have been purchased since certain 

requirements were not met, specifically: 

Questionable Eligibility 

The loan was processed as if a 10 percent owner of a company was purchasing 100 percent ownership 

of the same company. Through the distribution of the loan proceeds; however, we did not find 

adequate documentation in the lender's loan file to support the Change of Ownership action. 

According to Standard Operating Procedure (SOP) 50 10 5(B), for a change of ownership the lender must 

verify that the transaction results in 100 percent ownership by the purchasing owners. The bank provided 

a narrative regarding ownership showing that three individuals shared the company with 85 percent, 10 

percent, and 5 percent of the ownership. However, the loan closing statements did not demonstrate 

that the individual with five percent ownership was bought out at closing. As a result, there is no 

assurance the transaction resulted in the borrower owning 100 percent of the business, as required by 

the SOP. 

Inadequate Assurance of Repayment Ability 

According to SOP 50 10 5(B), the lender's analysis must include a financial analysis of repayment ability 

based on historical income statements and/or tax returns and projections, including the reasonableness 

of the supporting assumptions. We found that the lender used a borrower-prepared, interim, sevenmonth financial statement for calculating repayment ability. The lender, however, did not identify that 

the financial statements contained discrepancies and omissions. Specifically, the interim income 

statement submitted on July 31, 2009, was missing three material expense items that were present on 

other historical financial statements provided to the lender. This included compensation of officers, 

salaries, and depreciation. Using historical data, we conservatively estimated these missing expenses, 

which resulted in an estimated loss of $329,968 instead of the $291,241 profit that was presented. 

Furthermore, there was evidence of off-book financing, which was missing from both the financial 

statements provided to the bank and the federal tax returns. The off-book financing included a 

restructured $785,055 promissory note dated July 10, 2009. The promissory note was issued to a 

company that later filed a court petition to enforce payment of the promissory note. These findings 

demonstrate that the lender did not consider all of the borrower's liabilities in its repayment ability 

analysis. A proper analysis would have identified the existence of a Uniform Commercial Code (UCC) 

financing statement filing dated March 25, 2009. This statement identified the borrower as the current 

debtor and would be evidence for additional unreported debt. 

5 American Recovery and Reinvestment Act of 2009, Public Law 111-5 

8 
Appendix II: [Ex. 4] 

The deficiencies on this loan resulted in a $669,963 improper payment that should be recovered. 

The lender, The Washington Trust Company, was authorized by the SBA to make guaranteed loans 

under the Preferred Lender Program (PLP). As a PLP lender, the bank was permitted to process, close, 

service, and liquidate loans with limited documentation and review by the SBA. The lender approved a 

$ [Ex. 4] Recovery Act loan on [Ex. 4], 2009, with a 90 percent SBA guaranty to the borrower for 

debt refinancing and working capital. However, the lender did not comply with the requirements for 

refinancing debt. The lender also did not obtain an appraisal on the property that was used as 

collateral, as required. The NGPC purchased the loan on December 17, 2010, for $669,963. This loan 

should not have been purchased since certain requirements were not met, specifically: 

Questionable Eligibility (Inappropriate Debt Refinancing) 

According to SOP 50 10 5(A), the lender must perform a written analysis that addresses all the issues of 

debt refinancing. The two business applicants had negative net worth as of December 31, 2008, of 

$140,075 and $317,022. Additionally, they were having difficulties paying the business loans that were 

to be refinanced with the subject SBA loan. The difficulties were evident as the bank accepted a payoff 

of $95,630 less than the amount due to rid itself of the non-performing loans. The lender did not 

consider that it- and the SBA- would likely sustain losses by refinancing the debt, and did not obtain 

additional collateral or alter loan terms to protect SBA's interests. Furthermore, the loan authorization 

indicated that the use of proceeds included debt refinancing of $854,000 and working capital of 

$146,000. However, the lender's narrative indicated that the $146,000 amount was actually used to 

refinance debt. Designating the funds as working capital may have allowed the lender to circumvent the 

refinancing requirements. For example, the original purpose of the loan was undocumented and that 

information is required for refinancing. 

Questionable Eligibility (Property Appraisal) 

According to SOP 50 10 5(A), the lender is required to obtain an appraisal for real property when the loan 

is greater than $250,000 and is collateralized by real property. The commercial property used as 

collateral for the loan was not appraised during the application process. The lender did not request the 

appraisal and an appraisal was not provided for the lender, as required. Instead, the lender used a 

September 2008 appraisal prepared for the bank holding the defaulted note that the subject loan was to 

refinance. The appraisal valued the property at $160,000. In June 2010, after the borrower's business 

showed signs of distress, the lender obtained its own appraisal of the property that valued the property 

at $70,000. 

9 
Appendix III: [Ex. 4] 

The deficiencies on this loan resulted in a $967,869 improper payment that should be recovered. 

The lender, High Trust Bank, was authorized by the SBA to make guaranteed loans under the Preferred 

Lender Program (PLP). As a PLP lender, the bank was permitted to process, close, service, and liquidate 

loans with limited documentation and review by the SBA. The lender approved a $ [Ex. 4] Recovery 

Act loan with a 90 percent SBA guaranty on [Ex. 4], 2009, to the borrower for refinancing real estate, 

capital equipment leases, and a line of credit. However, the lender did not analyze repayment ability 

based on historical income statements and projections, including the reasonableness of the supporting 

assumptions to ensure the business' cash flow were adequate to service the debt. The NGPC purchased 

the loan on April 8, 2011, for $967,869; however, this loan should not have been purchased since certain 

requirements were not met, specifically: 

Inadequate Assurance of Repayment Ability 

According to SOP 50 10 5(B), the lender's analysis must include a financial analysis of repayment ability 

based on historical income statements or tax returns and projections, including the reasonableness of 

the supporting assumptions. The lender performed repayment ability calculations based on the 

borrower's projected net income for 2009. We determined that the accepted projected financial 

statements had material deficiencies and lacked supporting assumptions. Specifically, the projections 

omitted the prorated share of employee benefits and the only supporting assumption for the projected 

net income was the lender's statement that lithe owner has taken drastic measures to reduce expenses 

and increase sales to level off the company." This statement was inaccurate based on the financial data 

provided by the borrower. Historical financial statements showed that this business did not have 

sufficient cash flow to service the debt. If the first quarter actuals were expanded for the three 

additional quarters, the financial statements would show a loss of $287,000 compared to the 

borrower's projected 2009 net income of $118,000. Additionally, the lender did not provide a sufficient 

and reasonable explanation for its projections. 

10 
Appendix IV: [Ex. 4] 

The deficiencies on this loan resulted in a $555,368 improper payment that should be recovered. 


The lender, Monadnock Community Bank, was authorized by the SBA to make guaranteed loans under 


the Preferred Lender Program (PLP). As a PLP lender, the bank was permitted to process, close, service, 


and liquidate loans with limited documentation and review by the SBA. The lender approved a $ [Ex. 4] 


Recovery Act loan with a 90 percent SBA guaranty on [Ex. 4], 2009, for the purchase of three businesses, 


and their assets, inventory, and working capital. However, the lender did not properly analyze 


repayment ability based on historical financial statements, or evaluate the need for an equity injection. 


The NGPC purchased the loan on August 25, 2011, for $555,368; however, the loan should not have been 


purchased since certain requirements were not met, specifically: 


Inadequate Assurance of Repayment Ability 

According to SOP 50 10 5(A), the loan request must be declined if the lender's financial analysis 

demonstrates that the small business applicant lacks reasonable assurance of repayment in a timely 

manner from the cash flow of the business. The lender's underwriting was insufficient to ensure 

repayment. 

The lender improperly calculated the total annual payments for the SBA Loan. The lender stated that 

the total required debt service was $115,638 when the loan agreements demonstrated it was $176,257. 

Additionally, the lender's own calculations of the Debt Service Coverage Ratios (DSCR) of 0.06 for 2007 

and 0.40 for 2008, demonstrated an inability for this business to service the SBA loan debt. There was 

also no explanation as to why the borrower's sales were expected to increase by $209,000, or 20 

percent in 2009 when the business appraisal estimated only a $10,000 increase. The borrower also 

overstated their income by approximately $12,000, or 7.1 percent, for 2007 when compared against tax 

returns. The adjustment yields an operating loss of $9,580. Based on the unsupported projections and 

insufficient historical cash flow demonstrated there was not reasonable assurance of repayment ability 

for this loan. 

Questionable Eligibility (Inadequate Analysis of Business Plan or Managerial Experience) 

Considering the borrower's prior incursion into this industry, which resulted in the board of directors 

removing him as president, a thorough analysis of a business plan and managerial experience would 

have been prudent. The lender, however, did not perform an analysis as to how the change of 

ownership would have benefited the businesses as required by SOP 50 51 5(A). The Lender did not 

document any industry related experience of the borrower or management experience related to 

geographic or product diverse entities. Furthermore, there was no business plan in place to achieve the 

successful integration and continued operation of the three businesses. 

Equity Injection Issue 

According to SBA's SOP 50 51 5(A), the lender must include in its credit analysis a detailed discussion of 

the required equity and its adequacy. The only recorded discussion or analysis of equity injection was a 

statement in the credit memorandum saying that the $106,000 certificate of deposit (CD) provided by 

the borrower as additional collateral would also be considered an equity injection. There is neither a 

record of the deposit nor any mention in the Loan Authorization. 

11 
Appendix V: [Ex. 4] 

The deficiencies on this loan resulted in a $310,637 improper payment that should be recovered. 

The lender, Plaza Bank, was authorized by the SBA to make guaranteed loans under the Preferred 

Lender Program (PLP). As a PLP lender, the bank was permitted to process, close, service, and liquidate 

loans with limited documentation and review by the SBA. The lender approved a $ [Ex. 4] Recovery 

Act loan with a 90 percent SBA guaranty on [Ex. 4], 2009, for debt refinancing. However, the lender 

did not properly analyze repayment ability based on historical financial statements and projections. 

Additional deficiencies included an inadequate analysis of managerial experience and an unverified 

equity injection. The NGPC purchased the loan on February 10, 2011, for $310,637; however, this loan 

should not have been purchased since certain requirements were not met, specifically: 

Inadequate Assurance of Repayment Ability 

The borrower's pro forma income statement for May 2009 through April 2010 included an approximate 

132 percent increase in sales and an approximate 133 percent increase in income when compared to 

the 2008 historical data. 6 Our review, however, did not identify support to justify this increase. 

Questionable Eligibility (Inadequate Analysis of Business Plan or Managerial Experience) 

To comply with 13 CFR 120.150(a), the character, reputation, and credit history of the applicant, its 

associates, and guarantors should be evaluated by the lender. During our review, we determined that 

the owner had made financial decisions that were detrimental to the continued success of the business 

prior to loan disbursement. Specifically, after renting the building for approximately seven months, the 

borrower purchased the building by signing two 6-month balloon payment notes totaling $1,750,000. 

However, the borrower did not have the certification needed to signify the business as a competent and 

reliable manufacturer. This certification is necessary to make competitive bids for contracts. 

Additionally, the borrower had a history of poor financial decisions. He had already filed for bankruptcy 

once, had installment agreements with the Internal Revenue Service for 2004 and 2007 back taxes, and 

was accumulating credit card debt to operate the business. 

Collateral Adequacy 

The lender applied a liquidation factor of 90 percent to calculate a collateral value of $1,494,000. 

However, no accompanying information was found to support why the SBA's recommendation of 

75 percent liquidation factor for commercial property was disregarded in lieu of a liquidation factor of 

90 percent. 7 

Additionally, the lender did not consider whether the $760,000 variance between the sales comparison 

approach and income approach to valuation was appropriate in its final value determination. There 

were additional assets available to secure the loan, and therefore, the inflated liquidation value of the 

commercial property allowed the lender to ignore the other available collateral and caused this loan to 

be insufficiently collateralized. 

6 Expanded to a 12-month period 

SOP 505102, Chapter 17, paragraph g.a. 

12 

7 
Appendix V: [Ex. 4] 

Equity Injection Issue (Unsubstantiated Equity Injection) 

The lender did not include the required $169,000 equity injection as an item in the loan authorization 

even though the bank required it in the credit memorandum. Additionally, the lender did not 

substantiate the source of the equity injection. The loan file included a gift letter, a bank statement 

showing fund availability for the gift, and a final closing statement showing a deposit of $172,000 into 

the lender's account. The file, however, did not contain any substantial evidence that the funds 

presented at closing truly originated from the gift check or wire transfer. According to SOP 50 10 5(A), 

large unexplained deposits should always be questioned and the source of the funds documented. 

A promissory note, IIgift letter" or financial statement alone is generally not sufficient evidence of cash 

injection. 

13 
Appendix VI: [Ex. 4] 

The deficiencies on this loan resulted in a $680,900 improper payment that should be recovered. 

The lender, American Bank of Commerce, was authorized by the SBA to make guaranteed loans under 

the Preferred Lender Program (PLP). As a PLP lender, the bank was permitted to process, close, 

service, and liquidate loans with limited documentation and review by the SBA. The lender approved a 

$[Ex. 4] Recovery Act loan with a 90 percent SBA guaranty on [Ex. 4],2009, to pay outstanding debt 

and purchase inventory and working capital, but did not adequately verify equity injection. The NGPC 

purchased the loan on March 31, 2011, for $680,900; however, the loan should not have been 

purchased since certain requirements were not met, specifically: 

Unsubstantiated Equity Injection 

The lender's credit memorandum and, more importantly, the SBA loan authorization required a 

$400,000 equity injection to be used for inventory purchases. Instead, the loan file evidenced: 

1. 	 Two wire transfer deposits totaling $100,000 from unidentified or unsubstantiated sources. 

2. 	 No proof of deposit into the business account for two checks totaling $100,000. 

3. 	 Three partial standby debt agreements totaling $350,000, two of which were executed 

approximately eight months after loan disbursements began and one executed at an unknown 

time. 

4. 	 Invoices for both equipment and inventory some of which were purchased as much as three 

months before the purported equity injections occurred and five months before the loan 

was approved. 

According to SOP 50 10 5(A), lenders must verify the injection prior to disbursing loan proceeds 

and must maintain evidence of such verification in their loan files. Furthermore, SOP 50 10 5(A) 

requires IIdebt that is on partial stand-by (interest payments only being made) may be considered 

equity only when there is adequate historical business cash flow available to make the payments." 

The two most recent tax transcripts provided by the borrower, prior to loan approval, showed an 

operating loss of $71,457 in 2006, and a loss of $314,897 in 2007. 

14 
Appendix VII: Agency Comments 

u.s. SMALL BUSINESS ADMINISTRATION 

WASHINGTON, D.C. 20416 

MEMORANDUM 


April 26, 2013 


To: 	 John K. Needham 

Assistant Inspector General for Auditing 

From: 	 John A. Miller 

Director, Office of Financial Program Operations 

Subject: 	 Response to Draft Advisory Memorandum Identifying $4.6 Million in Improper 

Payments on Six 7(a) Recovery Act Loans, Project No. 12503A 

On February 17, 2009, President Obama signed into law the American Recovery and 

Reinvestment Act of2009 (the "Recovery Act") (P.L. 111-5). The Recovery Act provided the 

SBA with $730 million to expand the Agency's lending and investment programs and create new 

programs to stimulate lending to small businesses. Of the $730 million received, $375 million 

was authorized for the SBA to (1) eliminate or reduce fees charged to lenders and borrowers for 

7(a) and 504 loans, and (2) increase its maximum loan guaranty to 90 percent for eligible 7(a) 

loans. The OIG conducted this audit due to concerns that lenders would not exercise due 

diligence in originating and closing loans given the 90 percent SBA guaranty reduced lender 

risk. 

The memorandum identifies six loans that OIG believes warrant immediate attention by the 

agency in order to recover $4.6 million of improper payments. The loans reviewed in the audit 

were purchased by the National Guaranty Purchase Center (NGPC) between February 17, 2009 

and January 31, 2012. Deficiencies identified in the six loans included: 

• Questionable Eligibility 

• Inadequate Assurance of Repayment Ability 

• Equity Injection Issues 

• Insufficient Collateral 

15 
The six loans were originated by Preferred Lender Program (PLP) lenders. The audit found that 

these lenders did not originate and close the six 7(a) Recovery Act loans in accordance with the 

SBA's rules and regulations, and commercially prudent lending standards. Furthermore, OIG 

believes that SBA loan officers at the NGPC did not identify the deficiencies in the six loans 

during their purchase reviews. 

In FY 2013, OFPO has continued its training ofNGPC finance professionals processing guaranty 

purchases for high dollar early defaults. To date, 21 of the 40 finance professionals have 

completed the intensive commercial lending and credit training and its certification test, with the 

remainder to complete the training by November. Additionally, OFPO has differentiated the 

standard given to NGPC staff so additional credit is given to support purchase reviews for early 

defaulted, high dollar loans. This differentiation on credit provides additional time for loan 

officers to be more effective and thorough during purchase reviews. Finally, OFPO has initiated 

risk management initiatives at NGPC including the close tracking of purchase deficiencies 

detected during quality control reviews and providing ongoing corrective action and education. 

NGPC and OFPO management will continue to collaborate with the OIG in an effort to reduce 

improper payments. 

Management's response to the recommendations in the draft report is noted as follows: 

1. Seek recovery of$1,425,247from Compass Bank on the guaranty paid by SBAfor the 

loan to [Ex. 4] 

OFPO does not concur with this recommendation based on the reasons provided by the OIG in its 

findings of Questionable Eligibility and Inadequate Assurance of Repayment Ability. OFPO is 

reviewing an additional issue that OIG did not identify, which may warrant full recovery from 

the lender. OFPO will report its findings to the OIG by June 15,2013. 

2. Seek recovery of$669,963 from the Washington Trust Company on the guaranty paid 

by the SBA for the loan to [Ex. 4] 

OFPO concurs with this recommendation regarding the OIG's findings of Questionable 

Eligibility. OFPO will request full recovery of $669,963 from the lender by May 31,2013. 

3. Seek recovery of$967,869 from High Trust Bank on the guaranty paid by SBAfor the 

loan to [Ex. 4] 

OFPO does not concur with this recommendation that the OIG's findings ofInadequate 

Assurance of Repayment Ability led to an improper payment. OFPO will enter this into the 

16 

OCA HQ denial review process no later than May 31, 2013. 

4. Seek recovery of$555,368from Monadnock Community Bank on the guaranty paid by 

SBA for the loan to [Ex. 4] 

OFPO concurs with this recommendation. OFPO agrees with OIG's findings of Questionable 

Eligibility, and will request full recovery of$555,368 from the lender by May 31,2013. 

5. Seek recovery of$310, 63 7 from Plaza Bank on the guaranty paid by SBA for the loan 

to [Ex. 4] 

OFPO concurs with this recommendation and the OIG's findings of an Equity Injection Issue 

(Unsubstantiated equity injection) for this loan. OFPO will request full recovery of$310,637 

from the lender by May 31,2013. 

6. Seek recovery of$680,900from American Bank ofCommerce on the guaranty paid by 

SBA for the loan to [Ex. 4] 

OFPO does not concur with the recommendation. The lender was contacted as part ofthe NGPC 

audit response effort, and has provided additional supporting information. All issues detailed in 

the subject finding have been resolved as a result of additional information provided by the 

lender. This information will be provided to the OIG to satisfy this recommendation. 

Thank you for the opportunity to review the draft memorandum. Please let us know if you need 

additional information or have any questions regarding our response. 

17