Small Business Administration: Review of 7(a) Guaranteed Loans to Select Franchisees
Released: 2013-11-13T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: From fiscal years 2003 to 2012, SBA guaranteed franchise loans under its 7(a) program totaling around $10.6 billion. SBA made guarantee payments on approximately 28 percent of these franchise loans, representing about $1.5 billion, according to SBA. GAO was asked to examine SBAguaranteed loans to franchisees, and to investigate an allegation that a loan agent provided exaggerated revenue projections to franchisees of the same franchise organization to help them qualify for SBA loans.

This report describes (1) the magnitude of SBA-guaranteed loans to franchisees of the franchise organization, and (2) the results of GAO's investigation into the allegation, and aspects of SBA's oversight of its 7(a) loan program with respect to loans made to franchisees of the franchise organization.

GAO examined SBA's loan data and files of loans made to franchisees. GAO used the franchise organization's revenue data to compare to revenue projections in SBA applications, as well as revenue reported in the organization's disclosure documents. As part of the investigative work, GAO interviewed the franchisor, loan agents, and select borrowers to better understand the franchising experience.

GAO is not making any recommendations. In their comments, representatives of the franchise organization state that GAO's comparison of average revenue in the disclosure document and the first-year average revenue calculation is potentially misleading and inaccurate. GAO disagrees, as discussed in more detail in this report.

section_title: What GAO Found
paragraphs: Analysis of guaranteed loans to franchisees of a select franchise organization reviewed by GAO, approved from January 1, 2000, to December 31, 2011, showed the Small Business Administration (SBA) approved a total of about $38.4 million for 170 loans made by 54 lenders. SBA's guaranteed portion on these loans was approximately $28.8 million. Of the total population of 170 loans, 74 loans defaulted, 55 of which (74 percent) originated from four lenders that had the highest loan volume and default rates on loans to the franchisees. SBA made guarantee payments of around $11 million on the defaulted loans to franchisees, including about $8.5 million in guarantee payments on the 55 defaulted loans from these four lenders. Of the 88 loans reviewed from the four lenders, 55 (63 percent) defaulted. In comparison, 19 of the 82 loans (23 percent) that originated at the other 50 lenders to the franchisees defaulted. As part of GAO's investigative work, GAO interviewed the owners of 22 franchisees of the franchise organization in GAO's review, of which 16 defaulted on their loans and 10 filed for bankruptcy protection. Interviewed franchisees noted difficulties meeting anticipated revenue estimates and limited access to information that would aid in business planning.

GAO was unable to conclusively determine whether the loan agent referred to GAO for investigation intentionally provided exaggerated revenue projections to franchisees to help them qualify for SBA loans, and SBA has taken initial steps to enhance program oversight. The loan agent stated that she obtained the revenue projections from her employer and former clients, one of which she identified. She then provided these revenue projections to clients. The employer and former client she identified denied providing the revenue projections to the loan agent. SBA's Office of Credit Risk Management debarred the loan agent and her employer for encouraging false statements, among other things, making them ineligible to work with the federal government for a period of 3 years beginning in January 2012. According to GAO's analysis, the first-year projected revenues on loan applications involving the loan agent or her employer were, on average, more than twice the amount of actual first-year revenue for 19 of the 24 franchisees reviewed. Potential franchisees should include first-year revenue estimates in their SBA loan applications. However, this information is not necessarily available to potential franchisees in the franchise organization's disclosure document, which provides information about the organization's financial performance representations and franchisees' estimated initial investment, among other things. Further, federal regulations do not require franchise organizations to provide actual first-year average revenues for start-up businesses in their disclosure document. Thus, potential franchisees may have to conduct due diligence to identify this information from other sources, if available. GAO also identified discrepancies and other issues in SBA's franchise loan data with respect to fields used for risk-based oversight of its loans portfolio, such as default status, number of loans, and loan agent information. SBA has taken, or is considering steps, to address these issues and enhance oversight of loan agents. For instance, SBA is working with a third-party vendor to replace SBA's current franchise codes with publicly available identifiers used in the franchise industry. At the time of GAO's review, it was too early in the process to assess the effectiveness of these actions.

section_title: Letter
paragraphs: From fiscal years 2003 to 2012, the Small Business Administration (SBA)  guaranteed 32,323 franchise loans under its 7(a) program—a lending  program intended to assist small-business borrowers, including  franchisees—totaling around $10.6 billion. SBA made payments to honor  its guaranty on approximately 28 percent of these franchise loans,  representing about $1.5 billion, according to SBA. The 7(a) program is  the primary lending program of SBA and guarantees as much as 75 or 85  percent of an outstanding commercial loan balance, depending on the   Proceeds from 7(a) loans may be used to establish a  size of the loan.new business or to assist in the operation, acquisition, or expansion of an  existing business, among other uses. The 7(a) program involves SBA,  commercial lenders, borrowers, and in some cases, loan preparers or  other agents, who are private entities that offer SBA loan application  services for a fee. Default on an SBA loan may result in taxpayer loss, as  well as potential personal hardship for the borrower, such as financial  distress or bankruptcy. As part of its oversight efforts, SBA generally  conducts reviews of all 7(a) lenders with SBA-guaranteed loan portfolios  of $10 million or more on a 12- to 24-month cycle. SBA can conduct  additional reviews of the lenders if it identifies specific performance  concerns.

We have previously reported on SBA’s oversight of the 7(a) program, in  particular SBA’s assessments of lenders’ practices for determining  whether borrowers were unable to obtain credit at reasonable terms in the  conventional lending market and the agency’s use of the lender risk-rating  system for oversight and predicting lender performance. We reported  that SBA’s 7(a) program had some program weaknesses, such as limited  guidance on how lenders should document that borrowers could not  obtain credit elsewhere. We made several recommendations, including  one that SBA issue more detailed guidance to lenders on how to  document their compliance with the credit elsewhere requirement. SBA  generally agreed and has taken some action in response, such as  revising its guidance to lenders on how to document their determination  that borrowers could not obtain credit elsewhere.

You asked that we examine SBA-guaranteed loans to franchisees, and to  investigate an allegation that a loan agent provided exaggerated revenue  projections to franchisees of the same franchise organization to help them  qualify for SBA loans. This report describes (1) the magnitude of SBA- guaranteed loans to franchisees of the franchise organization, and (2) the  results of our investigation into the allegation, and aspects of SBA’s  oversight of its 7(a) loan program with respect to loans made to  franchisees of the franchise organization. Any mention of franchisees  throughout this report refers to borrowers obtaining SBA-guaranteed  loans to open or acquire one specific franchise. Reference to the  franchise organization refers to the overall franchise and its management.

To conduct our audit work, we examined data for all SBA-guaranteed  loans to franchisees of the select franchise organization approved from  January 1, 2000, to December 31, 2011, in order to assess loan volume,  default rates, and the amount of SBA’s guarantee payments made for 170  loans to franchisees from 54 lenders. We selected this date range in  order to obtain a broad understanding of SBA-guaranteed loans to  franchisees during different economic conditions and from multiple  lenders. The original dataset we received from SBA included 184 loans to  franchisees; however, 16 of these indicated that the lender canceled the  guarantee on the loan and 2 were outside the scope of our review. We  therefore excluded these loans from our analysis. From these data, we  selected four lenders with the highest loan volume and default rates.  Three of these four lenders are preferred lenders, which mean they have  delegated authority to make lending decisions on behalf of SBA. We also  reviewed 88 SBA loan packages for these four lenders in order to  examine characteristics of individual loans, such as the extent to which  the franchisees’ projected first-year revenues differed from actual first- year revenues, as well as to assess the accuracy of certain data fields in  the SBA franchise loan data. These loan packages included all loan  packages for these lenders during this time period. We assessed the  reliability of the SBA loan data by comparing it to information in loan files  for the four lenders and interviewing knowledgeable agency officials. We  found discrepancies between data in SBA’s loan database and  information in the loan files we reviewed, as discussed later in this report,  but we determined that the SBA loan data were sufficiently reliable for  reviewing loans to franchisees.

We analyzed revenue data that we obtained from the franchise  organization to calculate actual first-year revenue of franchisees, when  possible. We compared these calculations with the projected revenues in  SBA loan applications for select franchisees. We also calculated average  revenues for a broader population of franchisees, and compared it to  average revenues reported in the franchise organization’s disclosure  documents. We identified several issues with the accuracy and  completeness of the franchise organization’s revenue data, including  missing, duplicate, and nonsequential revenue data. For purposes of data  reliability, we excluded these businesses from our calculations. However,  after assessing the reliability of the revenue data, we determined that they  were sufficiently reliable for purposes of our analysis.

We also interviewed SBA officials about their activities related to  oversight of the four lenders to the franchise organization, efforts to track  and monitor loan agents, and assistance provided to potential franchisees  during the loan application process. In addition, we examined SBA’s  policies and procedures for overseeing lenders in the 7(a) program. We  also reviewed reports by SBA’s Office of Inspector General (OIG) and  other related documents.

To conduct our investigative work, we reviewed an allegation that a loan  agent intentionally exaggerated first-year revenue projections on SBA  loan applications in order to ensure that potential franchisees would  qualify for SBA-guaranteed loans. We interviewed the owner of the  franchise organization, the loan agent who was the subject of the  allegation, her employer, eight former franchisees that were referred to us  during the course of the investigation, and a bank officer who reviewed  loans related to the allegation. To better understand the franchisees’  experience with the 7(a) program, we interviewed 14 additional  franchisees of the select franchise organization. We selected these  franchisees on the basis of a range of factors, including whether they  used a loan agent, geographic dispersion, and performance status of the  loan. The 14 franchisees received 19 SBA-guaranteed loans from one of  the four lenders included in our review. In addition, on the basis of the 88  loan packages we reviewed for the four lenders, we identified 24  franchisees that used the loan agent connected to the allegation or her  employer, 19 of whom had data available to compare the first-year  revenue projections on SBA loan applications with the franchisees’ actual  first-year revenue. We are unable to generalize our findings from these  interviews and analysis to other franchisees, loan agents, franchise  organizations, or borrowers in the 7(a) program. Our intent was not to  identify potential fraud or abuse for all franchise loans of the franchise  organization, or the 7(a) loan program as a whole.

We conducted this performance audit from March 2012 to September  2013, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence that provides 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 objectives. We conducted  our related investigative work in accordance with the standards  prescribed by the Council of the Inspectors General on Integrity and  Efficiency. For a more detailed description of our scope and methodology,  see appendix I.
subsections: section_title: Background
paragraphs: SBA’s 7(a) loan program is intended to help businesses obtain credit that  they are unable to secure in the conventional lending market. Under the  7(a) program, SBA guarantees loans made by commercial lenders.  Borrowers may use 7(a) loan proceeds to establish a new business,  expand an existing business, or purchase an existing one, including a  franchised business. Loan proceeds can be used to buy equipment,  finance working capital, purchase or renovate a building, and pay for  other expenses. Currently, the maximum loan amount for a 7(a) loan is $5  million. The average 7(a) loan for fiscal year 2012 was $337,730. Loan  maturities vary based on the borrower’s ability to repay and the intended  use of loan proceeds.

To qualify for a 7(a) loan, the applicant must be deemed creditworthy,  have demonstrated an inability to obtain credit elsewhere on reasonable  terms from nonfederal sources, and be able to reasonably ensure  repayment. Lenders are required to consider these factors for each  applicant. In addition, lenders are required to report any fees paid to loan  agents, and other agents who assist the borrower during the loan  origination process, using the “Fee Disclosure Form and Compensation  Agreement” (Form 159). In general, examples of loan agents include: (1)  loan packagers, who are agents compensated by loan applicants or  lenders to prepare loan applications; (2) referral agents, who refer loan  applicants to lenders or vice versa, and may be compensated by either  party; and (3) lender service providers, who carry out lender functions in  originating, disbursing, servicing, or liquidating SBA loans in return for  compensation from lenders.

SBA’s Preferred Lenders Program (PLP) is part of SBA’s effort to provide  streamlined financial assistance to the small-business community,  including franchisees. Under this program, SBA delegates the final credit  decision, as well as most servicing and liquidation authority and  responsibility, to a group of preferred lenders. SBA relies on these  lenders to ensure that borrowers meet the program’s eligibility  requirements. SBA considers potential preferred lenders on the basis of  their performance records with SBA, and they must have demonstrated a  proficiency in processing and servicing SBA-guaranteed loans. In fiscal  year 2011, SBA had 3,537 active lenders in the 7(a) program, 545 of  which had preferred lender status.

SBA’s Office of Credit Risk Management conducts on-site reviews of  certain lenders through a risk-based review process. On-site reviews are  generally to be conducted on all 7(a) lenders with outstanding balances of  $10 million or more on the SBA-guaranteed portions of their loan  portfolios. SBA’s risk-based review process is to consider factors such as  portfolio performance, SBA management and operations, credit  administration practices for both performing and nonperforming loans,  and compliance with SBA requirements. According to SBA’s procedures  for conducting on-site risk-based lender reviews, SBA can assess a  lender as (1) acceptable, which means the lender is managing a  satisfactory SBA loan program using prudent lending practices and  representing limited financial risk to SBA; (2) acceptable with corrective  actions required, indicating the lender may have weaknesses, but it is  reasonably expected that the lender can address the issues during the  normal course of operations; (3) marginally acceptable with corrective  actions required, meaning the lender demonstrates serious deficiencies  and demonstrates an inadequate degree of understanding and  management of the SBA loan program; and (4) less than acceptable with  corrective actions required, which means the lender is operating an SBA  loan program with serious deficiencies or represents significant financial  risk to SBA.

When a borrower with an SBA-guaranteed loan defaults, the lender has  the option of submitting a purchase request to SBA to honor the  guaranteed portion of the loan. Effective November 15, 2010, SBA  defined an early defaulted loan as one in which the borrower defaulted  within 18 months of initial disbursement. Prior to that date, early  defaulted loans were those that defaulted within 18 months of final  disbursement. Early defaulted loans may indicate potential deficiencies in  the originating, closing, and servicing of loans. According to SBA’s  procedures, the agency must review guaranty purchase requests for early  defaulted loans with a higher degree of scrutiny than other defaulted  loans.

16 C.F.R. § 436.2. This regulation was issued by the Federal Trade Commission. performance representations in the FDD, which can include average  revenue figures and other earnings statements, are optional and can vary  by franchise organization. Current regulations stipulate that the financial  performance representation must have a reasonable basis and  substantiation at the time it was made. Potential borrowers have the  option to request additional information from the franchise organization  regarding the financial representations made in the FDD. In addition,  franchise organizations may provide the names and contact information  of current and former franchisees in the FDD.

section_title: Defaulted Loans to Franchisees of the Franchise Organization Resulted in $11 Million in Guarantee Payments, and Four Lenders Accounted for about 74 Percent of Defaulted Loans
paragraphs: Our analysis of SBA-guaranteed loans to franchisees of the franchise  organization approved from January 1, 2000, to December 31, 2011,  showed that SBA approved a total of about $38.4 million for 170 loans  made by 54 lenders. SBA’s guaranteed portion on these loans amounted  to around $28.8 million. Of the total population of 170 loans, we identified  74 defaulted loans, 55 of which (74 percent) were originated by four  lenders. Three of these four lenders are preferred lenders that have  delegated authority to make lending decisions on behalf of SBA. SBA  made guarantee payments of around $11 million on the defaulted loans,  including about $8.5 million in guarantee payments on the 55 defaulted  loans from these four lenders. Figure 1 illustrates the dollar value of  SBA guarantee payments for loans from the four lenders. In addition,  figure 1 shows that loans originating with Lender A and Lender B  comprised about 64 percent of the $11 million in guarantee payments  disbursed by SBA for loans to the franchisees of the franchise  organization.

Of the 88 loans we reviewed from the four lenders, 55 (about 63 percent)  defaulted. In comparison, 19 of the 82 loans (23 percent) that originated  at the other 50 lenders to the franchisees defaulted. As shown in figure 2,  two lenders—Lender A and Lender B—represented about 82 percent of  the defaulted SBA-guaranteed loans to franchisees from the four lenders  (45 of the 55 defaulted loans), and over half of the total defaulted SBA- guaranteed loans to franchisees from all the lenders (45 of the 74  defaulted loans).

SBA oversees preferred lenders, in part, through its risk-based review  process. SBA conducted such reviews on these four lenders, and found  in 16 of 17 reviews conducted that the lenders’ management of their SBA  loan programs was either acceptable or acceptable with corrective  actions required. One of the five reviews for one lender, Lender A,  determined the lender’s management was marginally acceptable with  corrective actions required, including improvements to the lender’s  policies, procedures, and controls for demonstrating certain underwriting  decisions. In September 2012, SBA OIG issued a report noting that  during SBA’s onsite reviews, the agency did not always recognize the  significance of lender weaknesses for 8 of the 16 sampled lenders and it  did not require lenders to correct performance problems that could have   SBA OIG made  exposed SBA to unacceptable levels of financial risks.six recommendations in the report, including proposals that SBA develop  and implement a process for assessing lender weaknesses in terms of  their risk to the agency, and that SBA tailor the scope of on-site reviews  of lenders to identify and address the weaknesses underlying lender  ratings. SBA agreed with the recommendations and the report noted it  has taken steps to address concerns in the lender oversight process. For  additional details on SBA’s risk-based review of the four lenders, see  appendix II.

In addition, as part of our investigative work, we interviewed the owners of  22 franchisees of the franchise organization to obtain background  information on the SBA loan process and efforts to start their  businesses. One franchisee we interviewed obtained an SBA-guaranteed loan that defaulted within 9 months of final disbursement,  making it an early defaulted loan. The franchisee highlighted challenges  related to insufficient working capital and unexpected expenses. The  franchisee ultimately filed for bankruptcy in March 2010. In addition,  franchisees we interviewed noted difficulties meeting anticipated revenue  estimates, as well as limited access to information that would aid in  business planning. While some of the franchisees we interviewed who  had not defaulted on their loan expressed similar challenges faced by  those with defaulted loans, one of the franchisees with a nondefaulted  loan told us he maintained excess capital in order to withstand slow  periods, and he highlighted previous business experience. The  experiences described in our interviews with the 22 franchisees are not  generalizable to the broader population of franchisees, other franchise  organizations, or 7(a) borrowers in general, but they provide additional  background and highlight some of the difficulties experienced by these  franchisees.

section_title: Alleged Loan Agent Fraud Could Not Be Conclusively Determined, and SBA Has Taken Initial Steps to Enhance Oversight of Loan Agents and Improve Loan Data Quality
paragraphs: We were unable to conclusively determine whether the loan agent  referred to us for investigation intentionally provided exaggerated revenue  projections to franchisees to help them qualify for SBA loans; however,  we found that first-year projected revenues on loan applications involving  the agent or her employer were, on average, more than twice the amount  of actual revenue for 19 of the 24 franchisees we reviewed in the first  year of operations. Our review of the allegation included obtaining  information on SBA’s efforts to track and monitor loan agent involvement  during the loan origination process. SBA has taken some steps to  enhance oversight of loan agents and to improve the completeness and  accuracy of data in its franchise loan portfolio.
subsections: section_title: Results of Investigation of Alleged Fraud Were Inconclusive
paragraphs: As part of our investigative work, we examined an allegation that a  specific loan agent provided exaggerated revenue projections to some  franchisees of the franchise organization in our review to assist them in  qualifying for SBA-guaranteed loans. Potential franchisees and lenders  may choose to employ loan agents to assist in the preparation of SBA  loan applications. In an interview in February 2012, the loan agent told us  she obtained the revenue projections from her employer and former  clients, one of which she identified. The loan agent told us she provided  these revenue projections to clients. The employer and former client she  identified denied providing the revenue projections to the loan agent.  SBA’s Office of Credit Risk Management debarred both the loan agent  and her employer, and they are ineligible to work with the federal  government for a period of 3 years beginning in January 2012. SBA  debarred the loan agent on the basis of evidence supporting other  grounds, including charging impermissible contingency fees, encouraging  7(a) loan applicants to violate SBA requirements by inflating working  capital requests, and directing prospective borrowers not to disclose fees.  In addition, the loan agent’s employer was debarred for impermissible  contingency fees and encouraging false statements in connection with the  7(a) program. On the basis of interviews with the loan agent, her  employer, eight former franchisees, and a bank officer for the loans, and  our associated audit work we could not conclusively determine whether  the loan agent intentionally provided misleading first-year revenue  projections to SBA loan applicants of the franchise organization.

section_title: Projected and Actual Revenue Differed, and Franchisees Should Exercise Due Diligence in Obtaining Accurate First- Year Revenue Projections
paragraphs: To better understand the role of loan agents and the preparation of SBA  loan applications, we interviewed three loan agents who were not the  subject of the allegation we received. These three loan agents stated that  they did not provide clients with revenue projections, and one of them  said it would be improper to do so. The Federal Trade Commission’s  Bureau of Consumer Protection (BCP) Buying a Franchise: A Consumer  Guide encourages franchisees to conduct due diligence on any earning  representations, including potential earning claims that the loan agent or  other individuals may provide.

During our review of the 88 loans files, we identified 6 loan agents,  including the subject of the allegation, who assisted franchisees in  preparing SBA loan applications. For SBA loans involving these loan  agents, to the extent possible, we assessed the accuracy of franchisees’  first-year revenue projections on their SBA loan applications by  comparing those figures to their actual first-year revenues using the  franchise organization’s revenue data. First-year revenue projections on  SBA applications that involved the loan agent we reviewed as part of our  investigation were, on average, higher than the franchisees’ actual first- year revenue. The magnitude of this difference was also higher than what  we found for other loan agents; however, the number of loans involving  loan agents with available data to make this calculation was limited and  the results are not statistically significant or generalizable to other SBA  loan applications.

Of the 88 SBA-guaranteed loans from the four lenders, we identified 24  franchisees with loans that indicated the loan agent referred to in the  allegation, or her employer, assisted the franchisee in preparing the SBA  loan application. Revenue projections from the loan application and  actual revenue data from the franchise organization were available for 19  of these 24 franchisees, all of whom were owners of start-up franchises.  On average, for these 19 franchisees, first-year revenue projections on  their SBA loan applications were 2.7 times the actual revenues the  franchisees made in their first year of operations. The first-year revenue  projections for these 19 loans ranged from 1.02 times to 8.6 times the  actual revenues the franchisee made in the first year of operations.

In the 88 loan files we reviewed for the four lenders, we found 10 loans  that involved a specific loan agent other than the one who was the subject  of the allegation. We found first-year revenue projections in the loan files  for 5 of these 10 loans. For these 5 loans, we compared the first-year  revenue projections from the loan files to the actual revenue of the  business during the first year of operations. The revenue projections for  the five loans were, on average, 1.5 times the actual revenues the  franchisees made in their first year of operations. The first-year revenue  projections on the SBA applications for these five loans ranged from 1.03  times to 2.8 times the franchisees’ actual first-year revenues.

In addition, federal regulations require franchise organizations to provide  potential franchisees with certain information in their FDD—the disclosure  document intended to aid individuals who are considering opening or  purchasing a franchise. While the franchise organization can choose to  include earnings statements in the FDD, federal regulations do not  require franchise organizations to provide actual first-year average  revenues for start-up businesses in the disclosure document.  Franchisees should include first-year revenue estimates in an SBA loan  application; however, this information is not necessarily available to  potential franchisees in the FDD and they may have to conduct due  diligence to identify this information from other sources, if available. For  example, some franchisees we interviewed said they relied solely on  information provided by the loan agent for developing revenue estimates.  Other franchisees we spoke to highlighted different sources of financial  information about the franchise organization, including existing or  previous franchisees and the franchise organization’s FDD when  developing revenue estimates.

Several franchisees told us that they use FDDs when developing revenue  estimates, but we found that the reported average revenue in the  franchise organization’s FDD tended to be higher than our calculated first- year average revenues. We reviewed the FDDs of the select franchise  organization in order to determine the average revenue it reported to  potential franchisees. The franchise organization’s average revenue in its  FDD accounted for all franchisees in operation the full calendar year  before issuance of the FDD, not just first-year average revenue. We  used the franchise organization’s revenue data to calculate, to the extent  possible, first-year average revenues for only its start-up businesses.  We then compared our first-year average revenue calculation to the  average revenue figures reported in the franchise organization’s FDD  over a 10-year period. For 9 of the 10 years we reviewed, the average  revenue in the franchise organization’s FDD was higher than our average  revenue calculations, after we excluded from our calculation all  businesses the franchise organization told us were not start-up  franchises. In addition, for the 10-year period the average revenue in the  franchise organization’s FDD had a median value that was 1.43 times our  average revenue calculation. In addition, we calculated the average  revenue figure for the franchise organization, including the 63 businesses  the franchise organization told us were not start-up businesses. The  result of this calculation did not differ substantially from the franchise  organization’s average revenues in the FDDs. See appendix III for  additional details about our analysis.

SBA’s website offers some information about the challenges of  franchising, and it directs potential franchisees to the website of the  Federal Trade Commission’s BCP for additional guidance. Likewise, the  BCP’s Buying a Franchise: A Consumer Guide warns potential  franchisees about unauthorized or misleading earning representations,  highlighting the importance of franchisees conducting due diligence when  applying for a franchise loan. According to SBA officials, SBA has limited  interaction with franchisees because it delegates the application process  to the preferred lenders. However, officials said individuals can visit one  of SBA’s district offices, which provide resources for starting a business.  Further, SBA has programs that are intended to help businesses start and  grow by providing training, counseling, and access to resources, such as  Small Business Development Centers, which provide services through  professional business advisors. We identified other resources available to  potential franchisees. For instance, a third party currently submits  Freedom of Information Act requests for SBA franchise loan data, which it  then uses to conduct franchise performance analysis. The analysis, which  includes default rates and charge-off rates listed by franchise  organization, is available to the public for a fee.

section_title: SBA Is Taking Steps to Enhance Oversight of Loan Agents
paragraphs: To enhance oversight of loan agents, in October 2010, SBA announced it  would begin requiring lenders to submit reports on fees paid to loan  agents and other agents who assist borrowers during the loan origination  process. SBA requires preferred lenders to submit a form, called the Fee  Disclosure Form and Compensation Agreement (Form 159), which SBA  officials said can be used to document information about participants in  the loan origination process, including whether a borrower used a loan  agent, and if so, the loan agent’s name, company, and compensation.

Lenders submit Form 159 to SBA’s fiscal and transfer agent (FTA), who  has been recording loan agent information on behalf of SBA since  December 2010.

Further, in March 2011, SBA published a notice with guidance to lenders  on how to submit the form to the agency’s FTA, and the notice highlighted  SBA’s efforts to create a database that would include all information on  the form.  SBA’s FTA maintains the database that includes information  from the form. In addition, during our review, officials said SBA is  adapting the form to obtain more-complete information about the role and  activities of individuals who assist potential borrowers during the loan  origination process, including loan agents. SBA plans to update the form  in fiscal year 2014. Officials further stated that SBA has taken, and is  considering, other steps to enhance oversight of loan agents. For  example, SBA has added a provision in its standard operating procedures  that allows the agency to fully deny liability in the event that the lender  makes a loan on the basis of a loan package prepared by a debarred loan  agent. In addition, the agency publishes a list of debarred individuals  including loan agents on its website.

Small Business Administration, Submission of Form 159 for 7(a) Loans, Information  Notice Number 5000-1200.

The NMLS is a record for nondepository, financial services licensing or registration for  participating state agencies. This is the sole system of licensure for mortgage companies  for 54 state agencies and the sole system of licensure for Mortgage Loan Originators for  58 state and territorial agencies. preferred lenders, since they have delegated authority over the loan  origination process.

section_title: SBA Has Initiated Efforts to Enhance Reliability of Some Franchise Loan Data
paragraphs: During the course of our review, we identified discrepancies in SBA’s  franchise loan data that highlight incomplete or inaccurate data in certain  fields SBA uses for risk-based oversight of its loans portfolio, which SBA  has initiated efforts to address. Using data from SBA’s Loan Accounting  System (LAS), in our review of the 88 loan files for four lenders of the  franchise organization with the highest loan volume and default rates, we  found discrepancies between the loan files and LAS. These discrepancies  generally represent two facets of data reliability—completeness and  accuracy. For example, we found differences with respect to dates of  defaults, default status, and whether the franchise was a start-up or  existing business. Table 1 provides an overview of the discrepancies we  identified.

SBA officials said the agency takes steps to ensure the reliability of its  loan data and has initiated efforts intended to improve the completeness  and accuracy of some fields in LAS related to its franchise loan portfolio  in general. Preferred lenders enter select data into LAS, and they certify  that the information they enter into the system is accurate and complete,  officials said. In addition, officials noted SBA assesses the accuracy of  certain data fields when the lender submits a monthly loan status report  or loan files to request a guarantee payment, and an external auditor  reviews a sample of loans in LAS to validate that the financial data for the  loans are accurate.vendor to improve the consistency of franchise information in its database  by replacing SBA’s current franchise codes with publicly available  identifiers used in the franchise industry, and to verify the accuracy of  franchise information in LAS that lenders previously entered. As of July  2013, officials said the franchise identifiers were ready for use, and the  agency planned to notify lenders about them. In addition, in August 2013,  officials said they estimate the franchise identifiers will be introduced at  the beginning of fiscal year 2014. SBA officials noted efforts to improve  historical franchise data would be contingent on funding. Because SBA’s   Officials also said SBA is working with a third-party  franchise data-improvement efforts are in the early stages, it is too soon  to assess whether SBA’s actions will address the issues with data  reliability we identified.

section_title: Agency and Third- Party Comments and Our Evaluation
paragraphs: We provided a draft of this report to SBA for its review and comment.  SBA provided technical comments, which were incorporated, as  appropriate. We also provided relevant sections of a draft of this report to  the four lenders who made loans to franchisees of the franchise  organization. We received technical comments from three of the lenders  and incorporated them, as appropriate, and one lender did not provide  comments.

In their comments, one of the lenders asked to be dropped from the  report because of what it described as a relatively fewer number of loans  and defaults compared to the other lenders. However, we included  information on the SBA-guaranteed loans made by this lender to  franchisees to provide more context and perspective on loans to  franchisees. While relatively smaller based on the number of made and  defaulted loans to franchisees than other lenders, it met our criteria of  lenders with the highest number of loans and defaults. The only other  lender with a comparable number of loans had one defaulted loan.

In addition, we provided a draft of this report to the franchise organization  for its review and comment. The representatives of the franchise  organization provided comments on a draft of this report, which we have  reprinted in appendix IV. In their comments, representatives of the  franchise organization stated that our comparison of average revenues in  the FDD and our first-year average revenue calculations is potentially  misleading and inaccurate because the two sets of data being compared  are not analogous. Specifically, representatives of the franchise  organization stated that we are comparing two different sets of data and  that we point out a significant difference in revenue without explaining the  differences in such figures. The representatives requested that we more  clearly state the differences between revenue information contained in the  FDD and our calculations, which we did.

However, we disagree with the representatives’ comments that our  comparison is potentially misleading and inaccurate. The report  comments on the use of the FDD for projecting first-year revenue, not on  the accuracy of the average revenue reported in the franchise  organization’s FDDs. Specifically, the report states that the average  revenue in the FDD accounted for all franchisees in operation the full  calendar year before issuance of the FDD. However, we added additional  language to clarify that our calculation is of first-year average revenue  obtained from reviewing additional revenue data we obtained from the  franchise organization. Our comparison highlights the difficulties of using  the FDD as a basis for projecting first-year revenues, since the revenue  reported in the franchise organization’s FDD is derived from businesses  in operation at least the full calendar year prior to issuance of the FDD.  As noted in our report, while franchise organizations can choose to  include earnings statements in the FDD, federal regulations do not  require them to provide first-year average revenues for start-up  businesses in the disclosure document. However, franchisees are  required to include first-year revenue estimates in SBA loan applications,  and this information is not necessarily available to potential franchisees in  the FDD; thus, they may have to conduct additional due diligence to  identify this information from other sources, if available. As noted in our  report, several franchisees told us that they use FDDs when developing  revenue estimates, and we found that the reported average revenue in  the franchise organization’s FDD tended to be higher than our first-year  average revenue calculations. The purpose of our analysis was not to  assess the accuracy of the franchise organization’s reported revenues in  the FDD, as the representatives suggest in their comments, but to  demonstrate how the FDD figures were, on average, higher than our first- year average revenue calculations.

In addition, as noted in the report, our calculation of average revenues  including existing businesses did not vary substantially from the franchise  organization’s figures. Representatives of the franchise organization  requested that we state more clearly in the text of the report that we did  not identify a substantial difference between our average revenue  calculations and the franchise organization average revenue in the FDD  when including existing businesses. We modified our report to more  clearly state this information. However, by excluding existing businesses  in our calculation, to the extent possible, we highlighted how average  revenues disclosed in the franchise organization’s FDDs tended to be  higher than first-year average revenues, which we believe is material to  our discussion about the importance of franchisees’ conducting due  diligence when applying for a 7(a) loan. The franchise organization  agreed that potential franchisees must be careful in using information in  the FDD for estimating first-year revenue. In addition, the representatives  of the franchise organization noted additional provisions in the FDD that  address how a prospective franchisee can gather further information. We  modified the report to include language to address this issue.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the acting Administrator of  the Small Business Administration, the appropriate congressional  committees, and other interested parties. In addition, the report is  available at no charge on the GAO website at http://www.gao.gov.

If you or your staff members have any questions concerning this report,  please contact Stephen M. Lord at (202) 512-6722 or lords@gao.gov or  Wayne A. McElrath at (202) 512-6722 or mcelrathw@gao.gov. Contact  points for our Offices of Congressional Relations and Public Affairs may  be found on the last page of this report. GAO staff who made major  contributions to this report are listed in appendix V.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report describes (1) the magnitude of Small Business Administration  (SBA)-guaranteed loans to franchisees of the franchise organization, and  (2) the results of our investigation into the allegation, and aspects of  SBA’s oversight of its 7(a) loan program with respect to loans made to  franchisees of the franchise organization.

To conduct our audit work, we examined data for all SBA-guaranteed  loans to franchisees of the select franchise organization approved from  January 1, 2000, to December 31, 2011, in order to assess loan volume,  default rates, and the amount of SBA’s guarantee payments made for 170  loans to franchisees of the franchise organization from 54 lenders. We  selected this date range in order to obtain a broad understanding of SBA- guaranteed loans to the franchisees during different economic conditions  and from multiple lenders. The original dataset we received from SBA  included 184 loans to franchisees; however, 16 of these indicated that the  lender canceled the guarantee on the loan and 2 were outside the scope  of our review. We therefore excluded these loans from our analysis of  SBA’s loan data for the franchise organization. From these data, we  selected four lenders with the highest loan volume and default rates.  Three of these four lenders are preferred lenders that have delegated  authority to make lending decisions on behalf of SBA. We also reviewed  88 SBA loan packages for these four lenders in order to assess  characteristics of individual loans, such as the extent to which the  franchisees’ projected first-year revenues differed from actual first-year  revenues, and to assess the accuracy of certain data fields in the SBA  franchise loan data. These loan packages included all loan packages for  these lenders during this time period. We obtained copies of SBA’s risk- based review reports for the four lenders. We also searched the website  PACER.gov to determine if any of the franchisees that received 1 of the  88 SBA loans filed for bankruptcy.information from the four lenders when available. To assess the reliability  of the SBA franchise loan data for the franchisees of the franchise  organization, we (1) interviewed agency officials knowledgeable about the  data, (2) performed electronic testing for completeness and accuracy on  select data fields, and (3) traced fields in SBA’s loan database to primary  source files when possible. We found discrepancies between data in  SBA’s loan database and information in the loan files we reviewed. We  discussed reasons for the differences between the data sources, as well  as the agency’s processes and policies for managing the quality of  franchise loan data, with SBA officials. After discussions with SBA, we  determined the SBA loan data were sufficiently reliable for reviewing  loans to the franchise organization.  Moreover, we analyzed revenue data that we obtained from the franchise  organization to calculate actual first-year revenues of franchisees, when  possible. We compared these calculations with the projected first-year  revenues in SBA loan applications for 19 franchisees who used the loan  agent, or her employer, who was the subject of the allegation. We also  used the franchise organization’s revenue data to calculate average first- year revenues for a broader population of franchisees, and compared it to  average revenues reported in the franchise organization’s disclosure  documents. We noted several data limitations with the franchise  organization’s revenue data. The scope of our review included  businesses with a full 12 months of revenue data that began from years  2000 to 2011, since our objective was to calculate an entire year of  business revenue for businesses that opened during that time period. The  original revenue data provided by the franchise organization included 746  businesses. After excluding 59 businesses with fewer than 12 months of  revenue data and 149 businesses that may have opened prior to January  2000 (16 businesses affected by both of these issues), the total  population of businesses in the revenue data was reduced to 554. In  addition, we identified 115 businesses with revenue data that highlighted  potential reliability issues, including missing, duplicate, and nonsequential  revenue data. For purposes of data reliability, we excluded these  businesses from our calculations, and conducted analysis on the  remaining 439 businesses. To the extent possible, we calculated an  average revenue figure that reflected first-year revenue of start-up   We obtained franchise loan  franchisees. Accordingly, for part of our analysis, we excluded 63  businesses from the revenue dataset that the franchise organization  identified as existing businesses, for a total population of 376 businesses.  The franchise organization was not able to confirm that it identified all  existing businesses, so our average revenue calculations may include  both start-up franchisees and existing franchisees. Nonetheless, we  believe the average revenue figures we calculated provide a reasonable  basis of comparison to projected revenues for select start-up franchisees,  as well the franchise organization’s disclosure documents. We discussed  this methodology with representatives of the franchise organization, who  confirmed our approach was reasonable. To further assess the reliability  of the revenue data, we interviewed representatives of the franchise  organization and performed electronic testing on the data provided. We  determined that the franchise organization’s revenue data were  sufficiently reliable for the purposes of this report.

We also interviewed SBA officials about their activities related to  oversight of the four lenders, efforts to track and monitor loan agents, and  the assistance provided to potential franchisees during the loan  application process. In addition, we examined SBA’s policies and  procedures for overseeing lenders in the 7(a) program. We also reviewed  reports by SBA’s Office of Inspector General (OIG) and other related  documents.

To conduct our investigative work, we reviewed an allegation that a loan  agent intentionally exaggerated first-year revenue projections on SBA  loan applications in order to ensure that franchisees would qualify for SBA  7(a) loans. We interviewed the owner of the franchise organization, the  loan agent who was the subject of the allegation, her employer, eight  former franchisees that were referred to us during the course of the  investigation, and a bank officer that reviewed loans related to the  allegation. To better understand the franchisees’ experience with the 7(a)  loan program, we interviewed 14 additional franchisees of the select  franchise organization who received 19 SBA-guaranteed loans from one  of the four lenders with the highest loan volume and default rates. These  franchisees were selected on the basis of a range of factors, including  whether they used a loan agent, geographic dispersion, and performance  status of the loan. We also interviewed three additional loan agents. In  addition, on the basis of the 88 loan packages we reviewed for the four  lenders, we identified 24 franchisees that used the loan agent connected  to the allegation, or her employer, 19 of whom had data available to  compare the first-year revenue projections on their SBA loan applications  with the franchisees’ actual first-year revenue. We cannot generalize our  findings from these interviews to other franchisees, loan agents, franchise  organizations, or borrowers in the 7(a) program. Our intent was not to  identify potential fraud or abuse for all franchise loans of the franchise  organization or the 7(a) loan program as a whole.

We conducted this performance audit from March 2012 to September  2013, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence that provides 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 objectives. We conducted  our related investigative work in accordance with the standards  prescribed by the Council of the Inspectors General on Integrity and  Efficiency.

section_title: Appendix II: Summary of Risk-Based Reviews of Four Lenders
paragraphs: As part of its oversight efforts, the Small Business Administration (SBA)  generally conducts reviews of all 7(a) lenders with SBA-guaranteed loan  portfolios of $10 million or more on a 12- to 24-month cycle. SBA can  conduct additional reviews of the lenders if it identifies specific  performance concerns. Officials highlighted additional factors that could  determine whether a lender is subject to a risk-based review, including  the lenders’ risk ratings, industry concentration, and the results of  previous reviews. SBA conducted risk-based reviews of the four lenders  we selected for further review. Table 2 summarizes the risk-based  reviews we received from SBA for the four lenders.

SBA has the authority to suspend, revoke, or deny renewal of or issue a  shortened period for delegated authority of preferred lenders. According  to officials, SBA suspended or revoked the delegated authority for two  preferred lenders in the 7(a) program from 2000 through 2012. Rather  than suspending or revoking delegated authority, officials said SBA is  more likely to deny a renewal of delegated authority or grant a shortened  renewal period, since the renewal period can be from 6 months to 2  years. From fiscal year 2009 through 2012, SBA denied delegated  authority to 367 lenders. In addition, approximately 1,058 lenders  received at least one shortened renewal of 6 to 12 months. SBA can also  place lenders on a “watch list,” which is one of SBA’s monitoring tools to  identify high-risk lenders that warrant elevated oversight attention.  Officials told us that high-risk lenders on the watch list include institutions  that have received a review assessment of less than acceptable with  corrective actions required and marginally acceptable with corrective  actions required.

According to SBA, it is developing a new lender oversight framework to  conduct risk-based reviews. This new framework of risk-based reviews is  intended to measure the level of risk of each lender participating in the  7(a) program. As part of this effort, SBA officials said that they plan to  conduct a pilot project to review 20 to 30 lenders, which is to include  evaluations of issues related to loan agents and franchisees. As of  August 2013, SBA had completed 18 pilot reviews. In addition, SBA  officials said the agency will conduct various types of risk-based reviews  based on issues unique to a particular lender.

section_title: Appendix III: Financial Disclosure Document (FDD) Analysis and Franchising Due Diligence
paragraphs: The franchise organization we reviewed included average revenue in the  FDD that accounted for all franchisees, including both start-up and  existing franchisees in operation the full calendar year before issuance of  the FDDs. We obtained and analyzed the franchise organization’s  revenue data to calculate first-year average revenues, to the extent  possible, and compared them to average revenues reported in the  franchise organization’s FDDs. We found the average revenues reported  in the franchise organization’s FDDs from 2000 to 2009 were higher than  our average revenue calculations, with the exception of 1 year.  Specifically, for the 10-year period of FDDs we reviewed, the average  revenue in the franchise organization’s FDD had a median value that was  1.43 times our average revenue calculation. The average revenue in the  FDD for 1 of the 10 years was lower than our average calculation (our  average revenue calculation was 90 percent of the FDD for that year).  However, for the other 9 years, the FDD was at least 1.35 times and at  most 1.74 times the average revenue figures we calculated.

As discussed, current federal regulations stipulate that franchise  organizations have discretion in what they report in the section of the  FDD that is devoted to earnings statements, provided there is a  reasonable basis and written substantiation for the information. All of the  FDDs we reviewed for the franchise organization cautioned potential  franchisees that they may not achieve the average revenue reported in  the FDD and that many factors influence the revenue of the franchise.  These FDDs also note that the potential franchisees accept the risk of not  achieving the stated average revenue, and that the franchise organization  has not audited nor in any other manner substantiated the truthfulness,  accuracy, or completeness of any information supplied by its franchisees.

section_title: Appendix IV: Comments from Representatives of the Franchise Organization

section_title: Appendix V: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts

section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Heather Dunahoo, Assistant  Director; Rick Hillman; Maria McMullen; Linda Miller; Gloria Proa; Gavin  Ugale; Elizabeth Wood; and Heneng Yu made key contributions to this  report.


Question-summary annotations: questions: question: What did GAO determine about SBA's loans?
answer: Analysis of guaranteed loans to franchisees of a select franchise organization reviewed by GAO, approved from January 1, 2000, to December 31, 2011, showed the Small Business Administration (SBA) approved a total of about $38.4 million for 170 loans made by 54 lenders. SBA's guaranteed portion on these loans was approximately $28.8 million.
child_questions: question: To what extent did these loans default?
answer: Of the total population of 170 loans, 74 loans defaulted, 55 of which (74 percent) originated from four lenders that had the highest loan volume and default rates on loans to the franchisees. Of the 88 loans reviewed from the four lenders, 55 (63 percent) defaulted. In comparison, 19 of the 82 loans (23 percent) that originated at the other 50 lenders to the franchisees defaulted.

question: How do guarantee payments on default loans affect the SBA?
answer: SBA made guarantee payments of around $11 million on the defaulted loans to franchisees, including about $8.5 million in guarantee payments on the 55 defaulted loans from these four lenders.

question: What did GAO determine about why these loans defaulted?
answer: As part of GAO's investigative work, GAO interviewed the owners of 22 franchisees of the franchise organization in GAO's review, of which 16 defaulted on their loans and 10 filed for bankruptcy protection. Interviewed franchisees noted difficulties meeting anticipated revenue estimates and limited access to information that would aid in business planning.

questions: question: What did GAO's assessment of SBA loans determine?
answer: GAO was unable to conclusively determine whether the loan agent referred to GAO for investigation intentionally provided exaggerated revenue projections to franchisees to help them qualify for SBA loans, and SBA has taken initial steps to enhance program oversight. The loan agent stated that she obtained the revenue projections from her employer and former clients, one of which she identified. She then provided these revenue projections to clients. The employer and former client she identified denied providing the revenue projections to the loan agent. SBA's Office of Credit Risk Management debarred the loan agent and her employer for encouraging false statements, among other things, making them ineligible to work with the federal government for a period of 3 years beginning in January 2012.
child_questions: question: What did GAO find regarding first-year revenue estimates?
answer: According to GAO's analysis, the first-year projected revenues on loan applications involving the loan agent or her employer were, on average, more than twice the amount of actual first-year revenue for 19 of the 24 franchisees reviewed. Potential franchisees should include first-year revenue estimates in their SBA loan applications. However, this information is not necessarily available to potential franchisees in the franchise organization's disclosure document, which provides information about the organization's financial performance representations and franchisees' estimated initial investment, among other things.

question: How do federal regulations influence this process?
answer: Further, federal regulations do not require franchise organizations to provide actual first-year average revenues for start-up businesses in their disclosure document. Thus, potential franchisees may have to conduct due diligence to identify this information from other sources, if available.

question: What steps can SBA take to improve their oversight of loan agents?
answer: GAO also identified discrepancies and other issues in SBA's franchise loan data with respect to fields used for risk-based oversight of its loans portfolio, such as default status, number of loans, and loan agent information. SBA has taken, or is considering steps, to address these issues and enhance oversight of loan agents. For instance, SBA is working with a third-party vendor to replace SBA's current franchise codes with publicly available identifiers used in the franchise industry.

questions: question: What did SBA's 7(a) program do?
answer: From fiscal years 2003 to 2012, SBA guaranteed franchise loans under its 7(a) program totaling around $10.6 billion.
child_questions: question: On what percentage of franchise loans did SBA make guarantee payments?
answer: SBA made guarantee payments on approximately 28 percent of these franchise loans, representing about $1.5 billion, according to SBA.

question: Why did GAO become involved in SBA's loan affairs?
answer: GAO was asked to examine SBAguaranteed loans to franchisees, and to investigate an allegation that a loan agent provided exaggerated revenue projections to franchisees of the same franchise organization to help them qualify for SBA loans.