Small Business Loans Program Loan Splitting and Other Events of Non-Compliance

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1 Small Business Loans Program Loan Splitting and Other Events of Non-Compliance May 21, 1998 Final Report Ernst & Young

2 SCOPE OF ENGAGEMENT... 1 DEVELOPMENT OF A FRAMEWORK... 1 ACT, REGULATIONS AND GUIDELINES... 1 INTERVIEWS... 3 FRAMEWORK... 3 SAMPLE SELECTION... 4 ACCESS TO LENDER FILES... 5 BIL LOAN FILE REVIEW... 6 OVERALL... 6 GENERAL COMMENTS ON LENDERS... 6 SAMPLE SIZE... 7 CONSTRAINTS OF PROCEDURES... 7 LOAN FILE REVIEW - GENERAL RECOMMENDATIONS... 8 DEFINING BORROWERS AND BUSINESS ENTERPRISE... 8 MISUSE OF THE SBLP... 8 MONITORING ADHERENCE TO THE SBL ACT... 9 LOAN FILE REVIEW - SPECIFIC ISSUES AND RECOMMENDATIONS Summary of Observations... APPENDIX A Case Summaries...APPENDIX B Ernst & Young

3 SCOPE OF ENGAGEMENT In accordance with Phase I of our engagement letter dated February 13, 1998,we have conducted a review of a sample of Business Improvement Loan ( BIL ) files to address the Small Business Loans Administration s ( SBLA ) concerns with regard to loan splitting and other acts of non-compliance with respect to the Small Business Loans Program (SBLP or the Program ). Specifically, we have: Developed a framework for assessing non-compliance with the SBLP; Applied the framework to a selected sample of BILS and Reported our results thereon. All available loan files selected have been reviewed pursuant to confidentiality agreements entered into with lenders. In conducting our review and developing the report, we have relied upon the following information within the BIL files: lender and borrower financial information, lender and borrower records. And general discussions with the lenders senior management. We have not performed an audit or other verification of such information and, accordingly, we express no opinion thereon. We have included general and specific recommendations in our report in order to assist the SBLA in addressing changes to the Act on a timely basis. DEVELOPMENT OF A FRAMEWORK In developing a framework to address BIL non-compliance we strove to gain a thorough understanding of the non-compliance issues facing the SBLA through the review of available reports and memorandums prepared by the SBLA, the Auditor General s report on the SBLP, the BIL Act, regulations and guidelines and discussions held with both the Auditor General and Small Business Loans Administration ( SBLA ) staff. This initial task was a necessary condition for the development of a framework which would sufficiently address various concerns with respect to non-compliance. Act, Regulations and Guidelines Section 3 the Small Business Loans Act sets out the conditions which must be met by a borrower in order to have its loses paid. Section 3 sets out ten conditions however for the purposes of our file reviews we focused on four of these Ernst & Young 1

4 conditions. They are as follows: With respect to loan splitting 3(2)(b) which requires the estimated gross revenue of the business enterprise (i) did not exceed five million dollars for the fiscal period of the business enterprise during which the loan was approved by the lender, or (ii) in the case of a business enterprise about to be carried on, was not expected at the time the loan was approved by the lender to exceed five million dollars for its first fiscal period that is not of less than fifty-two weeks. 3(2)(d) which states the total of the following amounts did not at the time the loan was approved by the lender exceed two hundred and fifty thousand dollars, namely, (i) the principal amount of the loan, and (ii) the aggregate balance outstanding of all guaranteed business improvement loans under this Act and the guaranteed business improvement loans under the Fisheries Improvement Loans Act previously made to the borrower and either disclosed to the lender by the borrower or which the borrower had knowledge. With respect to security 3(2)(g) which requires the repayment of the loan was secured in the prescribed manner. More specifically our procedures were directed at evidence of cost, value and payment for assets. We referred to the checklist set out in Section 9 of the SBLA Guidelines for Lenders, paragraphs n),p)and q) which state respectively the following documentation should be on the lender file: evidence... to support the cost of assets financed (i.e. invoices, contracts, purchase and sale agreements, etc.) ; evidence... to support that the assets financed by the loan were paid by the borrower (i.e. canceled cheques, vendor s receipted invoice, or vendor s declaration) ; and independent appraisal... for non-arm s length transactions. The requirement for an appraisal is set out in paragraph 11 of the regulations. With respect to fees charged 3(2)(f) no fee, service charge or charge of any kind was by the terms of the loan payable to the lender in respect of the loan as long as the borrower was Ernst & Young 2

5 not in default, other than (i) a prescribed fee or charge, (ii) a charge not exceeding the amount of the fee payable by the lender pursuant to paragraph (4)(b), and (iii) interest at a rate not exceeding the prescribed maximum rate or the maximum rate determined by the prescribed formula or formulae. With respect to lender diligence There is no requirement in the Act in this regard, however, the Introduction to the Guidelines indicates lenders are expected to make business improvements loans with the same care as in the conduct of their ordinary business. Interviews We interviewed SBLA Account Managers in order to obtain an understanding of non-compliance. The account managers have extensive experience with the Program and have each encountered incidents of non-compliance resulting in the rejection or reduction of a claim for loss. We inquired with Account Managers as follows: When is non-compliance detected? What procedures are used to check for non-compliance? What is the process for dealing with non-compliance? What type of non-compliance is of the most concern? Are there any loan attributes which are predictors of non-compliance? In addition, we supplemented our interviews with a review of files that had been sent to the RCMP for investigation and discussions with staff from the Office of the Auditor General who were involved in that office s review of the Small Business Loans Program. Framework Overall, the framework has been designed with the intent of identifying BIL loans that not only appear to be in non-compliance of the Small Business Loans Act, regulations and guidelines, but also to report on any BIL loans that are not within the spirit of the SBLP. Our review focused on the following areas (along with the general procedures performed): Review for evidence of the possible existence of a business enterprise for the sole purpose of obtaining more than $250,000 in BILs or to fall under the $5,000,000 revenue threshold or related groups obtaining BILs in excess of Ernst & Young 3

6 $250,000 (a.k.a. loan splitting); Examination of the support for assets financed by the BIL loans to detect evidence of cost exceeding fair value at the time of purchase. Procedures included a review of source documentation contained within the BIL loan file supporting the assets financed for questionable items, identification of possible non-arm s length transactions, review of any valuations on file for independence and credentials; The lenders loan approval process including risk assessment, e.g. credit bureau reviews, assessment of management ability and reputation, analysis of business plans and cash flow forecasts and the security obtained. We also examined, where applicable, the loan default process, including the lenders workout process when in default, methods of realization from the assets financed and pursuit of personal and corporate guarantees, allocation of proceeds from realization of assets financed by the BILs versus non-bils and preparation of the BIL claim form; and General comparison of the loan files to the Guidelines to detect any evidence of non-compliance issues, inter alia, administration fees, personal guarantees in aggregate exceeding 25% of original loan amount. Our procedures would not necessarily detect fraud as by its nature fraud is accompanied by actions to conceal its occurrence, however, we did design and perform our procedures with a view to determining if there was a probability of fraud. Sample Selection Selection of the BIL files was based on a stratified database provided by the SBLA, from which a non-random sample was selected with a view to ensuring broad coverage of the total BIL population within the stated criteria. The primary criteria were financial institutions (six selected); geographic location (Toronto, Ottawa and Montreal) and date of registration (post December 31, 1994). The institutions selected represent greater than 64% of lending by dollar value for the year ended March 31, 1997 while the Ontario and Quebec regions represent 66% of lending in dollar value for the 1997 SBLP annual report. From this data we proceeded to select loans with a goal of obtaining a sample containing loans with/without claims and representing various industries, loan purposes and values (emphasis on higher value loans). The sample selection method is not intended to result in a representative sample Ernst & Young 4

7 of the entire BIL population, nor is the sample size necessarily sufficient to obtain representative results and, accordingly, extrapolation of the findings of our sample may be inappropriate should one attempt to address the issues concerning the entire BIL population based on the reported findings. We did not use a statistical sample as such a sample would have necessitated gaining access to a significant number of files from a greater number on lenders over a number of geographical areas within each institution. As a result, the cost of conducting the analysis would have been significantly greater and we do not believe a statistical sample would have provided any more meaningful results. We do believe that the sample selected is broad enough and sufficient in number to uncover evidence of systemic non-compliance issues within the institutions that were selected. Access to Lender Files After selecting our sample we negotiated confidentiality agreements with lenders. The primary concerns of the lenders were maintaining confidentiality of their customer information and ensuring neither they nor their customers were identifiable in our report, accordingly our report is non-specific with respect to lenders and borrowers. Each lender provided a senior manager to oversee the review process, however no lenders provided direct access to their account managers. As each lender retains its file documentation in a different manner the documents which we were provided access to differed for each lender. Ernst & Young 5

8 BILL LOAN FILE REVIEW Overall Appendix A summarizes our observations with respect to the files selected for review in accordance with the framework previously set out in our report. As noted in Appendix A these findings should not be extrapolated to the BIL portfolio as they are based on a non-statistical sample. The aggregate number of observations is not representative of the number of files on which we made observations as some files resulted in more than one observation. Our observations include circumstances which appeared to either be in breach of the Act and/or the regulations or which could be an indication of BIL process being possibly misused. We confirm, however, that in conducting our review, we did not have access to the borrowers or lending officers and relied solely upon review of loan files. It is possible that some observations of possible breaches of the Act and/or the regulations could have been explored by the borrowers or lending officers involved in the loan. There was no commonality of industry, lending institution, geographic location or borrower principals in the files on which we had observations which has led us to conclude that loan splitting and fraud are not pervasive problems within the BIL portfolio represented by the institutions selected for the review. General Comments on Lenders The significant parties involved in the SBLP processes include the borrowers, the lenders, SBLA staff and third parties such as vendors, purchasers, appraisers, receivers, trustees and other professional advisors. Lenders play a significant role and we considered their processes during our review. Based upon our examination of the BIL loan file sample, we noted one case where, the loan file was lacking a comprehensive credit review which for most files included detailed risk assessments, evidence of standard due diligence procedures such as PPSA and credit bureau searches, analysis of financial statements if available, management ability assessments, support for assets purchased, registered security to fully encumber the assets financed and personal guarantee(s) for the maximum allowable amount. We noted that in most cases, the loan files contained a business plan and/or cash Ernst & Young 6

9 flow projections. In a small number of instances, the loan file did not contain this information which is a normal when completing a comprehensive loan assessment. Also noteworthy was the lack of discussion or analysis on file with respect to the borrowers business plans or projections. However, it may be the case that these steps were performed but not documented by the lender. From our examination of the BIL claim files, typically, the lender approached the default process with a view to minimizing the shortfall. With respect to asset realization, in most cases competing bids were obtained and in complex situations, an agent was appointed to assist the lender. Furthermore, typically, the lenders displayed appropriate pursuit of personal guarantees and in some cases accepted reasonable compromises in order to minimize professional fees. Notwithstanding the lenders thorough loan assessment process, in many cases the overall credit risk was assessed as high. In one instance, the lender had documented in a BIL file that acceptance was granted solely due to the government guarantee. We reviewed one file which had no evidence of a credit review having been performed however the loan had been assigned a credit rating. Sample Size Lenders were unable to locate eight of the 110 files selected for review. These files had either been misplaced by the lenders or were incomplete. In most cases, the file was inactive due to either the loan being paid out or being a paid claim file; in which case, the file was archived by the lender. Due to time constraints, no additional loans were selected for review. Constraints of Procedures Our procedures were limited solely to the documentation contained in each BIL file provided to us by the lenders. We did not conduct any discussions with the individual loan officers responsible for the BILs, nor did we perform any site visits of the borrowers premises. Furthermore, we cannot attest to the completeness or accuracy of the documentation within each loan file. Accordingly, in some cases, the documentation contained within a BIL file may have been insufficient with respect to determining or finding evidence of noncompliance with the SBLP. Ernst & Young 7

10 LOAN FILE REVIEW - GENERAL RECOMMENDATIONS This section contains general recommendations arising from our review. Our recommendations relate primarily to SBLA s need to clarify the definition of terms in the Act and to clarify the program objectives thus setting acceptable uses for the Program. More specific recommendations with respect to particular issues arising during the course of the review are set out in the following section. Defining Borrowers and Business Enterprise The most problematic area of our review was dealing with loan splitting issues. The framework we developed was based on the premises that the existence of separate enterprise solely for purpose of obtaining a BIL or related groups obtaining more than $250,000 in BILs constitutes loan splitting. For purposes of this report we have made observations on those files where there was documented evidence of related groups or where we had reason to believe there may have been related groups with BILs in excess of $250,000. In addition we also made observations on files where there was no apparent reason for the separate existence of separate borrowers other than to obtain BILs. The difficulty assessing the occurrence of loan splitting is the result of the terms borrower and business enterprise: as they are used in the Act not being specifically defined. Furthermore, the Notice to Lenders contemplates a situation whereby two borrowers with identical beneficial ownership would not be considered to be loan splitting if certain criteria are met with respect to their loans. As a result, under the current Act and available guidance borrowers and lenders could argue that due to ambiguity of definitions that loan splitting has not occurred. Recommendation The terms borrower and business enterprise need to be defined clearly and communicated to those seeking BILs as well as to lenders. Misuse of the SBLP As part of our review we noted files which were either in breach of the Act or which raised questions about loans being made which had the appearance of potential misuse of the SBLP. These files included inter alia cases where: franchisees obtained BILs where the franchisee and franchisor had significant Ernst & Young 8

11 economic ties. the principal(s) of failed companies which had BILs bought the assets back from a receiver or trustee. assets previously financed by a BIL were repurchased with a new BIL. The appearance of misuse of the SBLP in the case of such loans is compounded by the SBLA not having clarified the program objectives and not having a mechanism for dealing with loans which may be technically compliant with the Act, but not in keeping with the SBLP objectives. Recommendation The SBLA must clearly define the objectives of the SBLP and obtain and exercise authority for rejecting claims for loans which are not in keeping with the SBLP objectives. Monitoring Adherence to SBL Act SBLA relies primarily on lenders to ensure borrowers are adhering to the Act. In addition the SBLA relies on lender s to perform due diligence as set out in the guidelines. Lender s have additional incentive to perform due diligence due to their exposure for a portion of BILs made by them. This reliance reduces the SBLA s administrative costs, however the only mechanism the SBLA has for ensuring reliance is warranted is the claim audit process. Recommendation SBLA may want to consider additional methods of monitoring compliance with the Act such as enhancing the information maintained in its loan database or obtaining the right to audit lender files either directly or with the assistance of lenders internal auditors. Ernst & Young 9

12 LOAN FILE REVIEW - SPECIFIC ISSUES AND RECOMMENDATIONS The specific issues arising out of our review of the BIL files are noted below along with a discussion of potential impact and our recommendations. We have considered the issues, results and our recommendations in light of the SBLA s objectives of making the Program accessible while limiting its availability to borrowers with alternate sources of financing and managing the risk and cost of defaulted loans. Following this discussion is an appendix (Appendix B) setting out in more detail the actual situations which lead to the issues identified (pursuant to the Confidentiality Agreements entered into by the lending institutions and Ernst & Young, our findings with respect to the extent and impact of non-compliance issues reported hereon will be non-specific with respect to both lenders and borrowers.) 1. Shell corporation set up solely for the purpose of obtaining financing for related corporation. Potential Impact Underlying value of the asset financed by the BIL loan may be significantly below cost. Furthermore, the corporation is likely to be economically dependent on the related company. The result of which is significant exposure to the SBLP due to the economic dependence and the value of the underlying asset in the event of a default. Such corporations may also result in a breach of the BIL and gross revenue limits set in the Act. Recommendation There is no recommendation as the SBLA has issued a Notice to all SBL lenders which sufficiently addresses this issue. For loans made in the next period consideration should also be given to the recommendation set out below. 2. Separate borrowers exist solely for the purpose of obtaining more than $250,000 in BILs or falling below the $5,000,000 revenue threshold. Potential Impact Separate borrowers which are part of a related group with an aggregate BIL loan balance in excess of the $250,000 limit or revenue in excess of $5, 000,000 results Ernst & Young 10

13 in increased overall risk and exposure to the SBLP especially in the case where related parties are all engaged within the same industry. This is also potential abuse of the SBLP which was intended to help small businesses which frequently lack financing capability versus providing financing to businesses that have sufficient financing capability but wish to take advantage of the limited risks of the borrowers under the SBLP. In order to address this issue the SBLA must consider the purpose and objectives of the SBLP, set limits on access to BILs which are clearly defined and set out information to be provided to enforce these limitations. These issues resulting recommendations are discussed below. 2.1 Limiting Borrowers Access to BILs The Notice to Lenders provides a very specific example of where multiple BILs which in total exceed the $250,000 limit are permitted. However, the specificity of this example causes difficulties for lenders and the SBLA. As the various types of operational relationships between borrowers are difficult to define, i.e. bar and restaurant, food and entertainment, equipment for continuous manufacturing process, retailer and wholesaler, a limitation based solely on ownership relationships should be considered. Furthermore, situations where borrower s are related tend to be situations that provide the appearance of misuse of the program. Recommendations The limitations set out in the Act could limit access to groups which are related as defined in the Income Tax Act as opposed to the current limitation on borrower. A stricter limitation could be achieved by limiting access to groups which are associated as defined in the Income Tax Act. Clarifying the definition of the parties to which the BIL limit and gross revenue limit applies may unduly limit access to BILs. In order to combat this a cap may be set for loans to related/associated borrowers which exceeds the current limits. The size of the cap will depend on the definition of related borrowers and the desire to provide access to BILs. Furthermore, a prohibition similar to the anti-avoidance provisions of the Income Tax Act could be added to the SBL Act to capture those situations which are contrary to the spirit of the Act but which meet the specific prohibitions with respect to related parties. Ernst & Young 11

14 2.2 Capturing Information with Respect to Limitations on the Amount of BILs Borrowers are Entitled to The current process relies on borrowers and lenders to adhere to the limitations on borrowing set out in the Act. As discussed above the ambiguity of the definitions with respect to these limitations provide borrowers and lenders with considerable leeway in interpreting these provisions of the Act. Furthermore, the ambiguity of the definitions makes it difficult for the SBLA to identify borrowers who are exceeding the limitations and thus take action to address misuse of the Program. Recommendation The SBLA may continue to rely on lenders and borrowers to apply the limitations on borrowing set out in the Act. Given that this area is problematic we recommend the SBLA give consideration to requiring borrower disclosure of related and/or associated parties, BIL amounts outstanding and group revenues to lenders as well as to the SBLA. Specifically borrowers should be required to disclose their owners and the names of related/associated entities at the time of loan application and lenders should be required to provide this information in order to register loans. This information can then be added to SBLA s database thus allowing SBLA to monitor compliance with and enforce the Act. Including this information in the database is of particular importance if a cap is to be set on borrowing as discussed above. In order to impress upon borrowers the importance of such information and the seriousness of falsely reporting the disclosure should take the form of a declaration. The declaration should advise borrowers of the consequences of making a false statement as set out in the Act. In addition the declaration could contain an excerpt of the Act as it relates to this limitation. 3. Inadequate support for the cost of the assets financed by the BILs. Potential Impact This will potentially result in the fair value of the assets being significantly less than the cost. The consequence of which, in a default situation, is a significant shortfall realized by the lender that could have been avoided. However, we do note that while suffering a significant shortfall is a necessary indicator of inflated asset cost, it is not a sufficient condition. In some instances, assets under a distress sale or immovable assets such as leaseholds may have minimal value notwithstanding cost was equal to fair value at the time of Ernst & Young 12

15 purchase. The overall result is potential undue exposure to the SBLP in the event of a BIL claim. Recommendation The SBLA should take steps to ensure that all BIL lenders exercise a high degree of care and due diligence when financing assets under circumstances such as: borrower purchasing assets at non-arms length; borrower purchasing assets from a vendor who is not the original manufacturer; borrower purchasing assets from a vendor who was the previous operator; borrower is a franchisee and is purchasing BIL eligible assets from either the franchisor or a related party of the franchisor; and in any other case where the lender may be unfamiliar with the asset to be financed by the BIl. A high degree of care and due diligence appropriate in the above circumstances would include an independent valuation to be obtained by the lender, or, in the case of the purchase and installation of leaseholds, two competing bids. Independent valuation to be defined as valuation performed on behalf of the lender by a valuator who has satisfactory credentials to perform the valuation. These steps will also aid in protecting an unsuspecting borrower who may, in some cases, lack the sophisticated business acumen skills necessary when entering into large purchase agreements. The SBLA should require lenders to make premises visits where the above circumstances exist. 4. Franchisee borrowers Potential Impact While franchising was not a prime focus within our framework, we have noted in several cases that a lender was providing financing to numerous franchisees within the same franchise. In one case, the aggregate BILs to a group of companies involved in the same business exceeded $1 million. Therefore, SBLP has significant exposure should the entire franchise concept fail. Ernst & Young 13

16 We also have documented several cases where the franchisor is providing not only the concept, but equipment and, in one case, leaseholds through a related company. In the case of the leaseholds, the cost appeared to be inflated. The franchisee may lack the sophistication to question the franchisor with respect to the costs and, accordingly, in some cases, the costs may exceed actual values. Overall concern is exposure to the SBLP if the franchise concept fails, resulting in multiple claims. In addition, possible undervalued assets that provide the underlying security to the BIL resulting in unnecessary shortfalls experienced by the lenders. Recommendation For the purpose of tracking SBLP s exposure to any one franchise, enhancements to both the loan registration form and the SBLA database should be considered. i.e. requiring franchisor names and operating names to be included in the database. SBLA should also consider obtaining the right to cap exposure to a particular franchise concept. With respect to purchasing assets from either the franchise or a related party, see comments above under the issue of support for asset purchases. Ernst & Young 14

17 APPENDIX A SUMMARY OF OBSERVATIONS Ernst & Young 15

18 Summary of Observations from BIL File Reviews* Observation # of Files Total sample size 110 Files not found out of sample of Company incorporated for the sole purpose of obtaining a BIL 1 Evidence or circumstances indicating a related group (as defined in the 7 Income Tax Act) obtaining more than $250,000 in BILs or a related group with revenue in excess of $5,000,000 obtaining a BIL regardless of the nature of the businesses. A lack of appropriate support for asset valuation such as absence of an 9 independent valuation where one was required, a combination of circumstance which cast considerable doubt on the reasonableness of the existence/value of the assets purchased or a complete lack of evidence of asset cost. Lender has charged fees on a BIL loan, other than the fees allowable under 1 the SBLP. Asset financed by BIL which was ineligible. 1 Personal guarantee in excess of the prescribed limit. 2 Insufficient evidence of lender s due diligence. 1 C The sample was non-statistical hence extrapolation of these findings to the BIL population as a whole is inappropriate. These observations may not represent actual non-compliance with the Act, however they have the appearance of being non-compliant and accordingly we have commented on them in our report. The observations are not mutually exclusive. More than one observation has been made on some files. Ernst & Young 16

19 APPENDIX B CASE SUMMARIES Ernst & Young 17

20 1. Example of a case in which a shell Corporation was set up solely for the purpose of obtaining financing for a related corporation. (i) A company ( Oldco ) entered into an agreement to sell an asset to a newly incorporated company ( Newco ). Financing of the purchase of the asset was performed through a BIL of $250,000. Newco also entered into an exclusive marketing agreement with Oldco, whereby Oldco would have exclusive rights to market and service the asset in return for a monthly fee payable to Newco which was sufficient to service the BIL debt held by Newco. The sole shareholder of a holding company ( Holdco ) had a significant interest in Oldco. The same shareholder also had a direct interest in Newco. The loan for financing Newco s purchase was registered prior to the Notice of Lenders was issued. The purchase and sale was clearly non-arm s length, however, the BIL file did not contain an independent valuation attesting to the value of the asset in question. Oldco entered into bankruptcy in early 1996 resulting in Newco s inability to service its debt. There was no realization from Newco s only asset, which had little value due to the dependency on Oldco to service this asset. In substance, the transaction was for the sole purpose of providing financing to Oldco which at the time was showing signs of financial difficulty (As noted in the loan file). The lender has yet to submit a claim as it continues to pursue the guarantor for payment of the personal guarantee. We note that this was the only example of a shell corporation found within the BIL loan sample. Furthermore, the loan was registered prior to the Notice to lenders dated May 13, 1996 which was issued specifically to deal with this issue. 2. Examples in which a separate enterprise exists solely for the purpose of obtaining more than $250,000 in BIL s: (i) Two companies ( Aco. and Bco. ) entered into an agreement to purchase the assets of an existing business. The total purchase price was over $400,000 which was to be financed through cash vendor take-back and combined BILs in excess of $300,000. Aco. and Bco. were owned by the same shareholders. The loan was approved and registered prior to the Notice to Lenders was issued, default occurred shortly thereafter and a claim was paid out in (ii) A newly incorporated company required financing to purchase equipment. The lender approved and registered the loan prior to the Notice to Lenders Ernst & Young 18

21 being issued. Two other companies were newly incorporated and believed to Be held by relatives of the borrower also purchased equipment which was related to the same process. It is noted in the loan file that all the equipment was required to fully complete the process. The same vendor was listed for all three processes and therefore highly likely to be in the same location. The BIL balances, if any, of the related companies were not noted on file, thus, we were unable to determine if the BIL balances combined would exceed the $250,000 limit. (iii) A corporate shareholder owned at least two companies each of which had a BIL. The aggregate BILs were in excess of $250,000. The existence of separate corporations operating from different geographical locations is not normal for this industry. (iv) Two companies 100% owned by the same principal obtained $500,000 in BILs to operate separate businesses from a common address. The loan was approved but not disbursed prior to the issuance of the Notice to Lenders. (v) Members of a family wholly owned companies which operated the same franchise concept from a number of different geographical locations. The family members appear to have over $250,000 in BILs. 3. Examples where support for the purchase price of the assets financed by BIL was inadequate: (i) Three instances of a non-arm s length purchases of assets with a BIL for which there was no independent valuation on file to support the cost. (ii) Two BILs were provided by a lender to finance the purchase of an existing company. Contained in the loan file was a valuation performed for the vendor, however, the valuation did not contain the appraiser s credentials and, furthermore, the overall appearance of the appraisal was unsophisticated. The loan went into default shortly thereafter and a significant shortfall was incurred. (iii) A lender provided a BIL loan in excess of $200,000 to finance the purchase of equipment to a newly created company. The lender performed a corporate search of the vendor to ensure the transaction would be at arm s length. Based on the corporate search, the parties were not related. By late October 1996, the loan was in default and an Agent was appointed to realize on the equipment. The realization was significantly below cost. The vendor s Ernst & Young 19

22 invoice lacked detail and generally appeared inadequate. (iv) A newly incorporated company requested a BIL loan in excess of $100,000 to finance leaseholds to begin a franchise. A party related to the franchisor was contracted to supply and install the leaseholds. There was no independent appraisal or competitive bids on file to verify the costs quoted by the contractor. The cost for the leaseholds appeared excessive. (v) A franchisee requested a BIL loan in excess of $100,000 to purchase equipment necessary for operations. All of the equipment was purchased from the franchisor directly. There was no documentation on file to support the franchisor s selling price of the equipment financed under the BIL 4. The lender has charged fees on a BIL loan, other than the fees allowable under the SBLP. We found one file where a fee was charged specifically for processing a BIL application. In certain cases there was evidence of fees having been charged, however, the fees related to non-bil products. In many cases, the lender offered an operating line or an overdraft protection and other services such as payroll services, cash concentration account, etc. We did not perform a detailed analysis to determine if fees charged were commensurate with the non-bil product or service provided, however, there was one case where a borrower obtained a BIL loan and a $25,000 line of credit. The lender charged a one-time $1,000 application fee for the line of credit which on balance, appeared excessive. 5. The lender has provided a BIL to finance assets that are ineligible pursuant to the Act. In one case, we noted that a small portion of a BIL had been used to finance costs that were no eligible. The loan went into default and the lender filed a claim to SBLP. We noted that the lender recognized the ineligibility of certain assets funded by BIL loans and adjusted its claim accordingly. 6. Guarantee in Excess of Prescribed Limit. in) A lender took a guarantee greater than the prescribed limit. The loan went into default and the claim was rejected as a result. ii) A lender took a guarantee within the prescribed limit, however, upon collection the lender charged, obtained and retained interest on the guarantee from the date Ernst & Young 20

23 of default to the date of receipt from the guarantor. 7. The Lender s file did not contain adequate evidence of due diligence. i) The evidence of due diligence was restricted to the lender having provided a credit rating for the prospective loan. Ernst & Young 21