SBA Lending Matters Newsletter
A Word from Arne

As I call on clients, I listen to community bankers across the country discuss the challenges facing our industry. Almost without exception, the conversation inevitably turns to the subject of the Basel III standards and their tougher capital adequacy requirements. In June of this year, the OCC, FDIC, and the Federal Reserve Board of Governors issued a joint proposal for the Basel III rules to be applied to all U. S. banks, regardless of asset size or business model. I’m not sure if people realize the impact that this across-the-board proposal would have on government-guaranteed loans and banks that benefit from SBA lending (see details below).

Local community bankers, already burdened with all the new regulatory challenges, may soon be forced to conquer a complex and daunting system for determining how much capital they must maintain. There’s little doubt that difficulties undergone by the banking industry recently have raised concerns about the need for quality supervision worldwide. However, the Basel III standards were originally designed to affect only large, international banks. It strikes me – and the bankers I talk with – that smaller, community banks should not be “painted with the same brush” as the big, internationally active financial firms. Doing so would cause significant hardship to Main Street banks, as well as the millions of credit-seeking farms and small businesses that could be potentially helped by USDA- and SBA-guaranteed loans.

The Expected Capital Impact on Smaller Banks
As currently proposed, Basel III will require banks of all sizes to maintain risk weighted capital of 7%, compared with current common-equity standards that are as low as roughly 2%. This is not good news for small community banks. The bankers at the smaller institutions I visit say they’ll have lots of trouble raising the additional capital required by Basel III, primarily because they don’t have access to capital markets. If the Basel III rules are applied to them, privately held community banks must significantly boost retained earnings, and /or sell stock privately to investors, to comply with the standards – in many cases diluting the ownership interests of multiple generations of family members. Plus, the inability of some community banks to efficiently raise capital may well lead to further consolidation of locally owned institutions.

How Basel III Penalizes SBA Lending
So, how does the proposed Basel III implementation specifically affect SBA lenders? One of the incentives for lenders to offer SBA loans is the ability to take advantage of the secondary market that exists for the sale of loan guarantees. All sales of SBA guarantees are executed on a servicing retained basis, and the lender retains the rights and obligations to service the loan. This standard sale activity creates a “servicing asset”. This asset is recognized on a lender’s balance sheet as an intangible asset, but it is significantly different from goodwill. Existing regulations recognize the unique nature of an SBA loan servicing asset, and provide for an exception to the capital calculation relative to goodwill. This exception has been well served for many years. The proposed Basel III rules effectively eliminate this exception, which will cause SBA lenders to recognize a charge to capital. This is excessively penal.

As a Preferred Service Provider of the ICBA, we strongly encourage readers to take advantage of the extended comment period, ending October 22, 2012, established by the OCC, Federal Reserve and FDIC. Those of us in the community banking industry are seeking a “carve-out“ exemption of Basel III requirements. If you have not yet commented on this critical issue, please do so.

Contact us with any questions regarding SBA lending and Basel III, or other SBA-related questions and issues. As a qualified Lender Service Provider, you can count on us to be your out-of-house SBA loan department.

Featured Article

Best Practices: Change of Ownership: Stock Redemptions
By: Katie O'Brien, Esq.

In recent years, many questions have arisen regarding how to structure a change of ownership transaction involving the purchase of stock so that it is eligible for SBA financing. SOP 50 10 5(E) (the "SOP"), which became effective on June 1, 2012, answered some of these questions. The SOP clarified that the loan applicant must be a business. Lenders can not extend a loan to an individual to purchase stock, even if both the individual and the business are co-borrowers.

If the change of ownership is between existing individual owners, this is fairly straightforward. The business must be the borrower and the business will use loan proceeds to purchase the stock from the departing owners through a traditional stock redemption. At the conclusion of the transaction, the remaining stockholders will own 100% of the outstanding stock of the business.

If the change of ownership involves an "outside" individual who wants to purchase all of the stock of an entity, the business, which is the borrower, will still use loan proceeds to purchase the stock of all current owners through a stock redemption. But the individual(s) who will be the new owners will need to use their own money to purchase stock from the company. This can occur simultaneously with the stock redemption or it can occur in a separate transaction. The SOP clarifies that the amount paid for the stock is determined by the business and new owners and that the SBA does not make such a determination. But even so, the amount paid by the individual(s) to purchase stock from the company must be consistent with the price per share paid by the business to redeem the stock.

The SBA also added a new provision in the SOP which gives borrowers an additional option when it comes to stock purchases. A borrower may choose to form an entity to purchase all of the stock of the selling business (with an SBA loan). The selling business would then be absorbed into the acquiring business, and the purchased stock would be retired.

Lenders must be careful to make sure that any owner of 20% or more of the business' stock at the conclusion of the transaction guarantees the loan. For example, if the change of ownership is between existing owners, an individual may own less than 20% of the company prior to the change of ownership; but if the individual will own 20% or more of the company once the business redeems the stock, he or she must guarantee the loan.

Another thing to keep in mind is that lenders must still obtain a certification from the borrower business, acknowledging that (i) the loan proceeds are being used to acquire all or part of the business' stock, (ii) the business promises to be jointly and severally liable for the debt, (iii) the loan constitutes sufficient consideration for such promise, and (iv) the business waives any defense relating to failure of consideration. This certification is required per the 7(a) authorization boilerplate.

It is important to keep in mind the change of ownership provisions so that Lenders can have confidence that they have structured their stock redemption loans in a way that will not jeopardize the SBA guaranty.

For more information regarding change of ownership or stock redemptions, please contact Katie at (215) 542-7070 or at [email protected].

Regulatory Corner

Update to Owner’s Life Insurance Requirements
Owner’s life insurance continues to pose issues for SBA lenders. In the past, owner’s life insurance was optional on the SBA loan application. However, a recent SBA policy notice has made this insurance an absolute necessity. The SBA is requiring owner’s life insurance on all loans sold in the secondary market in order to protect the integrity of the guarantee. Failure to comply with this requirement could place the guarantee in jeopardy and the lender would be responsible for any loss. The following is the requirement according to the SBA SOP:

“Lender must determine if repayment of the loan is dependent upon an owner’s active participation in the business. In other words, if the owner dies, will the business operations be adversely affected and the loan default? In these situations, the lender must require life insurance unless the lender determines, due to the adequacy of collateral and/or the presence of secondary sources of repayment, that life insurance is not necessary. Lender must document this determination in the credit memo.  If the lender determines that life insurance is not necessary and there is a loss on the loan due to the death of the owner, the lender will be responsible for the loss.”

The last provision can potentially put the lender in a vulnerable position in the event of a guaranty claim. Therefore, we require the owner’s life insurance coverage to be clearly documented in the application.  Please call your Holtmeyer & Monson representative for additional details on this issue.

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A large function of our Portfolio Management service is to ensure that all loans comply with the SBA’s interest rate requirements.  The Agency does not require a specific interest accrual method to be used unless the loan is sold in the secondary market. In that case, either a 30/360 or Actual/365 interest accrual method is mandated. (A 365/360 accrual method is not permitted because it would cause the Annual Percentage Rate to exceed the SBA’s regulatory maximum.) As a service to new clients, Holtmeyer and Monson will assure regulatory compliance by performing a detailed analysis of the accrual method for all SBA portfolio loans. Contact Penny Newbauer or Arne Monson for more information.


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