Performance Audit 


Purchase Reviews Allowed $3.1 Million in Improper Payments on 7(a) 


Recovery Act Loans 


January 29, 2014 Report Number 14-09 
u.s. Small Business Administration 

Office of Inspector General 

Washington, D.C. 20416 

REPORT TRANSMITTAL 

REPORT No. 14-09 

DATE: 	 JANUARY 29,2014 

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

SUBJECT: 	 Purchase Reviews Allowed $3.1 Million in Improper Payments on 7(a) Recovery Act 

Loans 

This report is the second in a series resulting from our ongoing audit of purchased 7(a) Recovery Act 


loans. The first report identified improper payments and recommended recovery on six purchased 


7(a) Recovery Act loans totaling $4.6 million. The purpose of this report is to notify you of improper 


payments made on an additional three loans and to recommend recovery of $3.1 million less any 


amounts received from liquidation. 


We conducted this audit 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 for our findings and conclusions based on our audit objectives. 


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


based on our audit objective. 


We appreciate the courtesies and cooperation of the SBA extended to the staff during this audit. 


Please direct any questions to me at (202) 205-7100 or Terry Settle, Director, Credit Programs Group at 


(703) 487-9940. 

*** 

/s/ 

Robert A. Westbrooks 

Deputy Inspector General 
What the DIG Reviewed 

The Recovery Act provided the Small Business 

Administration (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 lenderr~k. 

This report is the second in a series resulting from our 

ongoing audit of purchased 7(a) Recovery Act loans. 

The first report identified improper payments and 

recommended recovery on six purchased 7(a) Recovery 

Act loans totaling $4.6 million. This report addresses 

improper payments on an additional three loans. 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. 

For the purposes of this audit report, we selected nine 

loans based on perceived risks using an internally 

developed OIG loan scoring system. We reviewed all 

loan origination, closing, and purchase actions as 

documented in SBA and lender loan files. We assessed 

these actions against all applicable SBA requirements. 

Further, we reviewed information in the SBA's Loan 

Accounting System for all loans examined. 

What the DIG Found 

The OIG found that three of the nine 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 Regulations. As the deficiencies identified in 

the three loans were not identified during SBA's 

purchase reviews, they resulted in inappropriate or 

unsupported disbursements of approximately $3.1 

million. 

These deficiencies were categorized into the following 

types based on the nature of their noncompliance: 

• Questionable Eligibility 

• Inadequate Assurance of Repayment Ability 

• Equity Injection Issues 

Additionally, we identified two loans totaling $2.5 

million that were not purchased in accordance with 

SBA's purchase review requirements and resulted in 

improper payments. However, documentation 

provided by the lenders during our audit mitigated the 

identified deficiencies and therefore, we are not 

recommending recovery of the guaranty amounts paid 

by SBA for these loans. 

DIG Recommendations 

We recommended that the Director, Office of Financial 

Program Operations: 

1. 	 Seek recovery of $1,473,770 (less any amounts 

received from liquidation) from TD Bank on the 

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

[Ex. 4] 

2. 	 Seek recovery of $685,691 (less any amounts 

received from liquidation) from Florida Community 

Bank (formerly First Peoples Bank) on the guaranty 

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

3. 	 Seek recovery of $897,091 (less any amounts 

received from liquidation) from Liberty Bank on the 

guaranty paid by the SBA for the loan to [Ex. 4, 6] 

[Ex. 4, 6] 

Management Response and Actions Taken 

The SBA agreed with each recommendation. The SBA 

has recently taken steps to improve the purchase 

review process for high-dollar early defaulted loans. 

Specifically, the SBA requires a quality control review to 

be performed on each high-dollar early defaulted loan 

before purchase. Additionally, the SBA has revised 

internal checklists to further assess repayment ability 

on early defaulted loans. Finally, the SBA has recently 

issued new procedures with revised underwriting 

standards for 7(a) loans. 
Table of Contents 

Introduction ............................................................................................................................................2 


Background .............................................................................................................................................3 


Results ....................................................................................................................................................4 


Conclusion .......................................................................................................................................6 


Recommendations ...........................................................................................................................6 


Agency Comments and GIG Response .............................................................................................. 6 


Appendix I: Scope and Methodology....................................................................................................... 8 


Appendix II: [Ex. 4] ......................................................................................................9 


Appendix III: [Ex. 4] .................................................................................................................... 11 


Appendix IV: [Ex. 4, 6] .................................................................... 12 


Appendix V: Agency Comments ............................................................................................................ 14 


1 
Introduction 

This report is the second in a series resulting from our ongoing audit of purchased 7(a) Recovery Ace 

loans. The first report 2 identified improper payments and recommended recovery on six purchased 

7(a) Recovery Act loans totaling $4.6 million. The purpose of this report is to notify you of improper 

payments3 made on an additional three loans and to recommend recovery of the related questioned 

costS.4 These improper payments were the result of lender deficiencies that were not identified during 

SBA's purchase reviews. The purchase reviews on these loans occurred between December 23,2010, 

and August 1, 2012. The total approved amount for these loans was approximately $3.4 million and the 

SBA purchased its guaranteed share of the principal loan balances for approximately $3.1 million. We 

are questioning the full $3.1 million of the SBA's purchased amount. Additionally, we identified two 

loans totaling $2.5 million that were not purchased in accordance with SBA's purchase review 

requirements and resulted in improper payments. However, documentation provided by the lenders 

during our audit cured the identified deficiencies and therefore, we are not recommending recovery of 

the guaranty amounts paid by the SBA for these loans. 

The loan deficiencies identified during the audit indicate there were serious flaws in the NGPC's purchase 

process at the time the loans were purchased. However, we previously issued two audit reports and made 

recommendations to address the deficiencies in the purchase review process. The recommendations 

included suggestions to: (1) establish a specialized early default purchase review unit and (2) 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. Further, the SBA has made progress in addressing these previous recommendations 

and improving its purchase process over high-dollar early-defaulted loans. 

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 applied the scoring 

system to a universe of 75 high-dollars early defaulted6 Recovery Act loans. Additionally, we eliminated 

loans that were involved in previous audits or were in an unstable status due to the SBA review process 

or guaranty repair action. We then selected nine loans that we were able to access from the National 

Guaranty Purchase Center (NGPC). 

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

2 Advisory Memorandum 13-16R, Purchase Reviews Allowed $4.6 Million in Improper Payments on 7(0) Recovery Act Loans, 

issued June 14, 2013. 

3 For the purpose of this report, 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. 

4 For purposes of this report, "questioned costs" are defined as costs questioned by the OIG, which were 

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

5 For purposes of this report, "high-dollar" is defined as loans approved for $500,000 or more. 

6 For purposes of this report, "early defaulted" as loans that default within 18 months of initial loan disbursement. 

2 

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 four of the nine loans reviewed. We also identified suspicious activity in one of the four 

loans with material deficiencies and referred it and another loan to the Office of Inspector General (OIG) 

Investigations Division. As a result, we omitted the details of these loans from this report. The 

remaining three loans with material deficiencies resulted in questioned costs totaling $3.1 million. 

To further 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 December 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. 

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's rules and regulations. 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. 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. 

Nature of Limited or Omitted Information 

We identified suspicious activity in two loans and referred them to the OIG Investigations Division. As a 

result, we omitted the details of these loans from this report. 

3 

Review of Internal Controls 

The SBA's internal control systems Standard Operating Procedure (SOpf provides guidance on the 

implementation and maintenance of effective systems of internal control as required by OMB.8 

According to OMB, effective systems of internal control improve the accountability and effectiveness of 

Federal programs and operations by establishing, assessing, correcting, and reporting on internal 

controls. 

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 aide in our understanding of the internal controls relevant to our on-going audit of 7(a) 

Recovery Act loans. 

Results 

The audit found that three 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 Regulations. 9 As the deficiencies identified in the three loans were not identified during SBA's 

purchase reviews, they resulted in inappropriate or unsupported disbursements of approximately $3.1 

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

requirements are summarized in Table 1, and include: 

Deficiency Type A: Questionable Eligibility 

According to SOP 50 10 5, 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 of Repayment Ability 

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

Applicant is the primary source of repayment, not the liquidation of collateral. Thus, if the 

lender's financial analysis demonstrates that the Small Business Applicant lacks reasonable 

assurance of repayment in a timely manner form the cash flow of the business, the loan request 

must be declined, regardless of the collateral available. 

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, the lender must include in its credit analysis a detailed discussion of the required equity and 

its adequacy. Additionally, SOP 50 51 requires lenders to verify the source as well as the 

existence of an equity injection that is greater than one-third 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 50513. 

7 SOP 00 02, Internal Control Systems. 


8 US Office of Management and Budget (OMB) Circular A-123, Management's Responsibility for Internal Control, 


2004. 

9 Title 13 Code of Federal Regulations, Business Credit and Assistance. 

4 

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. 

Table 1 Summary of Findings 

loan 

Number 

Borrower's Name Deficiency 

Type 

Amount 

Approved 

SBA Guaranty 

Amount 

Questioned 

Cost/\ 

[Ex. 4] [Ex. 4] A,B,C $1,640,000 $1,476,000 $1,473,770 

[Ex. 4] [Ex. 4] B $750,000 $675,000 $685,691 

[Ex. 4, 6] [Ex. 4, 6] A,B $999,950 $899,955 $897,091 

Total $3,389,950 $3,050,955 $3,056,552 

Source: SBA Loan Accounting System and OIG results 

Legend: A) Questionable Eligibility B) Inadequate Assurance of Repayment Ability C) Equity Injection Issues 

1\ Includes interest purchased 

The loan deficiencies identified during the audit indicate there were serious flaws in the NGPC's purchase 

process at the time the loans were purchased. 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 high-dollar 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. 

Further, the SBA has made progress in addressing the report recommendations and improving its 

purchase process over high-dollar early-defaulted loans. Specifically, the SBA has: (1) required quality 

control reviews prior to loan purchase on all high-dollar early defaults, (2) revised internal checklists to 

further assess repayment ability on early defaulted loans, and (3) issued new procedures with revised 

5 

underwriting standards for 7(a) loans. Future audits and additional loan reviews will assess the process 

after the full implementation of our recommendations. 

Conclusion 

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

accordance with the SBA's rules and regulations, and commercially prudent lending standards. 

Furthermore, SBA loan officers did not identify the deficiencies in the three loans during their 

purchase reviews. The SBA purchased its guaranties on these three loans, which resulted in 

approximately $3.1 million of questioned costs. As a result of the identified deficiencies, we 

recommend that the SBA seek recovery of approximately $3.1 million less any amounts received from 

liquidation. 

Recommendations 

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

1. 	 Seek recovery of $1,4 73,770 (less any amounts received from liquidation) from TD Bank 

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

2. 	 Seek recovery of $685,691 (less any amounts received from liquidation) from Florida 

Community Bank (formerly First Peoples Bank) on the guaranty paid by the SBA for the 

loan to [Ex. 4] 

3. 	 Seek recovery of $897,091 (less any amounts received from liquidation) from Liberty 

Bank on the guaranty paid by the SBA for the loan to [Ex. 4, 6] 

[Ex. 4, 6] . 

Agency Comments and OIG Response 

On December 23, 2013, we provided a draft of this report to the Director of the Office of Financial 

Program Operations for comment. On January 23, 2014, the Agency submitted formal comments, which 

are included in their entirety in Appendix V. A summary of management's comments and our response 

follows. 

General Management Comments 

The Agency agreed with all of our recommendations and stated that it has made progress in improving 

its purchase process. The SBA stated that it has required quality control reviews of high-dollar early 

default loans, enhanced its internal control checklist to further assess repayment ability on early default 

loans, and issued new procedures with revised underwriting standards for 7(a) loans. The SBA stated 

that it is also continually improving its processes and quality control program in the NGPC. 

The SBA noted that the NGPC concurred with one loan and did not concur with the other two. Finally, 

the SBA noted that all three cases have been transferred to Headquarters, where they are undergoing 

the Office of Capital Access' (OCA) Denial Review Process, with appropriate action to be taken upon final 

resolution. 

6 
OIG Response 

We commend the Agency's OFPO on its efforts to improve its purchase review process. We note that 

the Agency agreed with our recommendations for recovery and that each loan will undergo review 

during the Office of Capital Access' (OCA) Denial Review Process. 

Recommendation 1- Seek recovery of $1,473,770 (less any amounts received from liquidation) from TD 

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

Management Comments 

The OFPO agreed with this recommendation. The OFPO stated that it will proceed with this loan 

according to the OCA's Denial Review Process. 

OIG Response 

Management's comments were responsive to the recommendation. The management decision 

for this recommendation is considered resolved and the recommendation will remain open 

pending final action. 

Recommendation 2 - Seek recovery of $685,691 (less any amounts received from liquidation) from 


Florida Community Bank (formerly First Peoples Bank) on the guaranty paid by the SBA for the loan to [Ex. 4] 


[Ex. 4] 


Management Comments 

The OFPO agreed with this recommendation. The OFPO stated that it will proceed with this loan 

according to the OCA's Denial Review Process. 

OIG Response 

Management's comments were responsive to the recommendation. The management decision 

for this recommendation is considered resolved and the recommendation will remain open 

pending final action. 

Recommendation 3 - Seek recovery of $897,091 (less any amounts received from liquidation) from 


Liberty Bank on the guaranty paid by the SBA for the loan to [Ex. 4, 6] 


[Ex. 4, 6] 


Management Comments 

The OFPO agreed with this recommendation. The OFPO stated that it will proceed with this loan 

according to the OCA's Denial Review Process. 

OIG Response 

Management's comments were responsive to the recommendation. The management decision 

for this recommendation is considered resolved and the recommendation will remain open 

pending final action. 

7 

Appendix I: Scope and Methodology 

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 75 loans that consisted of high-dollar early defaulted Recovery Act loans that were a part of the 

Preferred Lenders Program (PLPj, which were purchased by the NGPC between February 17, 2009, and 

December 31,2012. Of the universe of 75 loans, we eliminated loans that were involved in previous 

audits or were in an unstable status due to the SBA's review process or guaranty repair action. We then 

selected nine loans that we were able to access from the NGPC. 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. 

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

documented in SBA and lender loan files. We assessed these actions against all applicable SBA 

requirements. We also reviewed information in the SBA's Loan Accounting System for all loans 

examined. 

Use of Computer-Processed Data 

We relied on information from the SBA's Mainframe Loan Accounting System to score loans using an 

internal scoring system developed by the OIG. Previous OIG engagements have verified that the 

information maintained in this system is reasonably reliable. Further, data elements associated to 

reviewed loans were verified against source documentation maintained in the SBA's purchased loan 

files. As a result, we believe the information is reliable for the purposes of this audit. 

Prior Coverage 

Small Business Administration-Office of Inspector General Reports 

Audit Report 12-11R, High-Dollar Early-Defaulted Loans Require an Increased Degree ofScrutiny 

and Improved Quality Control at the National Guaranty Purchase Center, issued March 23, 2012. 

Audit Report 12-18, A Detailed Repayment Ability Analysis is Needed on High-Dollar EarlyDefaulted Loans to Prevent Future Improper Payments, issued August 16, 2012. 

Advisory Memorandum 13-16R, Purchase Reviews Allowed $4.6 Million in Improper Payments 

on 7(0) Recovery Act Loans, issued June 14, 2013. 

8 

Appendix II: [Ex. 4] 

The deficiencies on this loan resulted in a $1,473,770 improper payment that should be recovered. 

The lender, TD 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 on [Ex. 4] , 2009, with a 90 percent SBA guaranty to [Ex. 4] for the purchase of 

land and improvements, construction, and working capital. However, the Lender (1) did not verify 

that the full amount of the equity injection was received, (2) processed the loan as a startup business 

instead of a change of ownership as required, and (3) did not properly analyze repayment ability 

based on historical financial statements. The loan defaulted within 15 months from the first 

disbursement with the borrower making only four of the required principal and interest loan payments. 

The NGPC purchased the loan on August 1, 2012, for $1,473,770. This loan should not have been 

purchased since certain requirements were not met, specifically: 

Equity Injection Issues 

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

and must maintain evidence of such verification in their loan files. Verifying a cash injection requires 

documentation such as a copy of a check along with evidence that the check was processed. 

Additionally, SOP 50 51 2(C), requires for any cash injection that is greater than one-third of the loan 

amount or $200,000, whichever is less, the lender must also verify and document the source of the cash 

injection. The loan authorization required that the borrowers inject $300,000 in equity prior to 

disbursement. The lender did not properly verify the source of the equity injection, that the money was 

injected into the business prior to disbursement of the SBA loan, or that the full amount of the equity 

injection was received. Loan documentation showed that $202,837 was provided in connection with the 

loan closing and at the time the SBA loan was disbursed. However, adequate documentation supporting 

the source of these funds was not provided. Finally, copies of three checks totaling $100,000 were 

provided by the borrowers at closing. However, no evidence was present in the loan file supporting that 

two of these checks totaling $50,000 were processed. 

Questionable Eligibility (Change of Ownership) 

The lender improperly categorized the business as a start-up even though the bank's own credit 

memorandum stated that the transaction was for the acquisition of an existing business. In addition, 

the sales agreement referred to as the IIAgreement for Restaurant Sale and Purchase" between the 

buyer and seller included restrictive covenants and goodwill. Finally, the settlement statement showed 

$601,000 of the transaction was for purchasing a business. Therefore, this loan should have been 

processed as a change of ownership and the lender should have adhered to SBA requirements that 

pertain to a change of ownership transaction. According to SOP 50 10 5(A), for a change of ownership, 

the lender must analyze and verify the historical earnings of the business and perform a business 

valuation. The loan documentation did not contain either of these. 

9 

Appendix II: [Ex. 4] 

Inadequate Assurance of Repayment Ability 

According to SOP 50 10 5(A), 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 loan documentation did not include an adequate assessment of 

reasonableness supporting how the business would achieve sales of $1.7 million within the first year. 

Additionally, the lender's analysis did not support how the business would achieve a net income before 

taxes rate that was more than three times the industry average. The absence of an initial month-bymonth financial analysis makes it difficult to evaluate repayment ability of a business in transition of 

ownership. This was especially important considering that there would be $150,000 of renovations that 

would impact the business' ability to generate revenue. The loan defaulted within 15 months from the 

first disbursement with the borrower making only four of the required principal and interest loan 

payments. 

10 

Appendix III: [Ex. 4] 

The deficiencies on this loan resulted in a $685,691 improper payment that should be recovered. 

The lender, Florida Community Bank (formerly First Peoples 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 on [Ex. 4] , 2009, with a 90 percent SBA guaranty 

to [Ex. 4] for working capital. The lender did not, however, properly analyze repayment ability as 

required and in accordance with prudent lending standards. The loan defaulted within 10 months from 

the first disbursement with the borrower unable to satisfy the 18-month interest only payment period 

established by the lender. The NGPC purchased the loan on May 23, 2011, for $685,691. 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(A), 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. The lender's analysis showed the borrower's company was 

insolvent. Specifically, net income for the business had declined from $947,424 in 2006 to ($816,624) in 

2008. Further, net income for the next 12 months of operations was projected to be ($671,041). The 

survival of the subject company, [Ex. 4] ,was largely dependent on working capital from the SBA loan 

to sustain the company until the housing industry recovered. However, there was no industry market 

analysis, support for pro-forma revenue projections, or evidence that the distributed working capital 

would be sufficient. 

In 2008, First Peoples Bank refinanced all outstanding debt of [Ex. 4] in the approximate amount 

of $3 million. As a result, the lender was at risk of substantial loss if the business failed. The business' 

Debt Service Coverage Ratio (DSCR) for three years prior to the approval of the SBA loan was (0.65), 

(0.40), (1.31), and for the pro-forma was (1.07). The lender's analysis did not predict adequate ability to 

service the debt until 2012, approximately two and a half years after the SBA loan was approved. 

Further, the lender's credit memorandum stated that $200,000, or 76 percent of the company's existing 

cash held as collateral, would be used to pay down the business' outstanding debt to First Peoples Bank 

once the SBA loan proceeds were disbursed. This was further evidence that the business was having 

trouble paying its existing debt. Finally, as the proceeds from the SBA loan would serve to replace the 

$200,000 of business cash used to payoff the lender's outstanding debt, this transaction could also be 

considered a transfer of risk from the lender to the SBA. 

11 

Appendix IV: [Ex. 4, 6] 

The deficiencies on this loan resulted in an $897,091 improper payment that should be recovered. 

The lender, Liberty 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 on [Ex. 4], 2009, which was subsequently modified to $999,950, with a 90 percent SBA 

guaranty to [Ex. 4, 6] (the borrower). The purpose of the SBA loan 

was for the refinance of a previous loan, repairs and maintenance, and working capital. However, the 

lender did not properly analyze repayment ability, the business plan and managerial experience of the 

borrower, the need for an equity injection, the underlying values of the liquidation plan for collateral, 

its ability to provide the loan under debt refinancing requirements, or the use of loan proceeds to pay 

past due taxes. The loan defaulted within 15 months from the first disbursement. The NGPC 

purchased the loan on January 7, 2011 for $897,091. 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(A), 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. Additionally, the SOP states that 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 tax returns 

for years 2006, 2007, and 2008 indicated a net business income of ($22,078), ($23,861), and ($11,034), 

respectively. The lender did not provide an income statement or statement of cash flows as required. 

Additionally, the lender used unsupported net operating income figures that conflicted with the 

businesses tax returns in their historical and projected debt service analysis. This is disconcerting 

considering the lender acknowledged within its credit memorandum that the business had poor 

financial record keeping and performance. 

The lender's credit memo stated that, liThe past two years of insufficient cash flow have caused 

deferred maintenance and past due taxes, both which will be remedied with loan proceeds." The loan 

file did not identify the amount required to become current on the borrower's taxes or satisfy 

maintenance requirements. Furthermore, this statement suggests that cash flow had historically been 

insufficient to maintain the business. It is also important to note that the business revenue was the 

borrower's only source of personal income. However, there was no mention of the borrower's draw 

on the business income or how the borrower had been financing his expenses while the business 

suffered. Because the loan files were missing key financial statements, we were not able to verify the 

lender's calculated repayment ability. Based on historical income information and statements made 

by the lender, however, we determined that it was reasonable to question the repayment ability of the 

borrower. This loan should not have been made and the SBA should not have purchased the guaranty 

without the required documentation supporting the lender's conclusion of repayment ability. 

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Appendix IV: [Ex. 4, 6] 

Debt Refinancing 

According to SOP 50 10 5(A), applications that include the refinancing of same institution debt may not 

be processed using PLP procedures. The lender improperly refinanced the debt of the borrower in a 

way that violated SBA regulations. In the loan authorization, $944,829 was listed as a use of proceeds 

for payment of outstanding debt on a note held by the previous owner of [Ex. 4] 

[Ex. 6] . [Ex. 6] has owned and operated the motel since July 2006 with original financing 

provided by [Ex. 6] . [Ex. 6] received a loan from Liberty Bank for which he used [Ex. 6] 

debt as security. By issuing the loan to [Ex. 6] ,the lender was in effect refinancing debt held by its 

own institution, which required the loan to be submitted to the SBA for review and approval. 

The repayment to [Ex. 6] allowed Liberty Bank to effectively refinance its unsecured note to 

[Ex. 6] with a secured SBA-guaranteed note to [Ex. 6] . The lender issued the loan to 

[Ex. 6] under the procedures of the Preferred Lending Program. 

By not following the SBA regulations pertaining to refinancing debt, the lender created a conflict of 

interest where the approval of the loan to the borrowers resulted in the fulfillment of a note held as 

security, which might not otherwise have been paid. In effect, the Bank swapped a loan that was 

unsecured for a loan based on [Ex. 4] repayment ability that was secured, effectively transferring 

its risk to the SBA. This gives the impression that the lender viewed the risk of the borrower not being 

able to repay its debt as substantial enough to warrant a new, SBA-guaranteed loan. 

Payment of Delinquent Taxes 

Per SOP 50 10 5(A), loan proceeds must not be used to pay delinquent IRS withholding taxes, sales 

taxes or other funds payable for the benefit of others. The lender approved a portion of the loan 

proceeds to be used to pay delinquent property taxes. However, the lender did not describe the exact 

amount of the loan proceeds, which would be used for this purpose. As they were likely paid from 

working capital proceeds, documentation was not available to determine the amount. 

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Appendix V: Agency Comments 

u.s. SMALL BUSINESS ADMINISTRATION 

WASHINGTON, D.C. 20416 

MEMORANDUM 


January 23, 2014 


To: 	 Robert A. Westbrooks 

Deputy Inspector General 

From: 	 John A. Miller 

Director, Office of Financial Program Operations 

Subject: 	 Response to Draft Report on Purchase Reviews Allowed $3.1 Million in Improper Payments 

on 7(a) Recovery Act Loans 

Thank you for the opportunity to review the draft report. We appreciate the role of the Office of 

Inspector General (OIG) plays in assisting management in ensuring that these programs are effectively 

managed. 

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

of 2009 (the IIRecovery 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 three loans that OIG believes warrant immediate attention by the agency in 

order to recover $3.1 million of improper payments. The loans reviewed in the audit were purchased by 

the National Guaranty Purchase Center (NGPC) between December 23, 2010 and August I, 2012. 

Deficiencies identified in the three loans included: 

• Questionable Eligibility 

• Inadequate Assurance of Repayment Ability 

• Equity Injection Issues 

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

lenders did not originate and close the three 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 three loans during their purchase reviews. 

SBA has made progress in improving its purchase process, as mentioned by OIG in the draft report. SBA 

has (1) required quality control reviews over high-dollar early default loan cases prior to loan purchase, 

(2) enhanced its internal control checklist to further assess repayment ability on early default loans, and 

(3) issued new procedures with revised underwriting standards for 7(a) loans. SBA is also continually 

improving its processes and quality control program in the NGPC. 

NGPC has reviewed and concurred with one of the three loans cited and does not concur with the 

remaining two cases. All three cases have been transferred to Headquarters, where they are 

undergoing the Office of Capital Access (OCA) Denial Review Process with appropriate action to be taken 

upon final resolution. 

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

1. 	 Seek recovery of $1,473,770 (less any amounts received from liquidation) from TO Bank on the 

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

OFPO concurs with this recommendation, and will proceed according to the OCA Denial Review 

Process. It should be noted that the NGPC did not concur with OIG's recommendation. 

2. 	 Seek recovery of $685,691 (less any amounts received from liquidation) from Florida 

Community Bank (formerly First Peoples Bank) on the guaranty paid by the SBA for the loan to 

[Ex. 4] 

OFPO concurs with this recommendation, and will proceed according to the OCA Denial Review 

Process. It should be noted that the NGPC did not concur with OIG's recommendation. 

3. 	 Seek recovery of $897,091 (less any amounts received from liquidation) from Liberty Bank on 

the guaranty paid by the SBA for the loan to [Ex. 4, 6] 

OFPO concurs with this recommendation, and will proceed according to the OCA Denial Review 

Process. NGPC concurred with OIG's recommendation. 

Again, thank you for the opportunity to review the draft report. Please let us know if you need 

additional information or have any questions regarding our response. 

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