In 2011, the SBA Office of Inspector General Found Fault in SBA Franchise Lending Practices

On July 13, 2011, the Small Business Administration Office of the Inspector General released an audit report entitled, “Banco Popular did not Adequately Assess Borrower Repayment Ability When Originating Huntington Learning Center Franchise Loans.”

Screenshot of cover page of audit report

The report states that the audit was conducted “in response to a complaint alleging that lenders improperly originated Small Business Administration (SBA) guaranteed loans made to HLCs.” HLC stands for “Huntington Learning Center,” the name of the franchise for which the loans were made.

The report states that the complaint “identified potential violations of 7(a) loan program rules” and that it alleged, in part, “that lenders approved the loans based on inflated gross revenue projections submitted by loan brokers in SBA loan applications.” SBA 7(a) loans are the loans commonly given to new franchiSEES.

The complaint appears to have been a general complaint about large-scale violations of lender practices. Theoretically speaking, any finding of impropriety in lending practices in this audit ought to have clued the SBA and Office of the Inspector General onto the fact that gross franchise lending violations are occurring across the industry en masse.

As we know from the title of the report, the Inspector General found Banco Popular to be at fault. The bank “did not adequately assess borrower repayment ability when originating… loans.”

The report states that the complainant personally received a loan to open a Huntington Learning Center franchise in 2007. The audit reviewed all 12 Huntington Learning Center loans that were approved by Banco Popular that fiscal year. It “reviewed SBA’s procedures governing loan approval and examined loan documents in the lender’s loan files” in order to “determine if the lender met SBA’s requirements for assessing the repayment ability of the companies.”

The audit was performed between March of 2010 and April of 2011 “in accordance with Government Auditing Standards prescribed by the Comptroller General of the United States.” The auditors “compared revenue data upon which the lender’s approval was based to revenue data in HLC Franchisor documents,” and they interviewed a former representative of the Franchisor, the complainant, other HLC franchise owners, and a representative of the lender.”

The audit results are chilling.

Consider this first paragraph in the section entitled, “Results in Brief.”

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Screenshot of first paragraph of 'results in brief' from audit

The audit found that “Banco Popular did not adequately assess repayment ability” for any of the 12 SBA-guaranteed loans it made for Huntington Learning Centers in 2007. It’s not that Banco Popular didn’t assess one or two loans of the loans correctly…. it’s that it didn’t assess any of them correctly. If SBA Standard Operating Procedures had been followed, none of the 12 SBA-guaranteed loans would have been funded. Not one of them.

And if none of the loans had been written, 12 franchiSEES would have been spared the incredible loss that comes with signing one’s name to a bad loan. Think of the pain the 12 families went through because the lenders didn’t follow the SBA Standard Operating Procedures correctly.

It only makes sense that Huntington Learning Center franchiSOR knew exactly what they were doing when they convinced the 12 franchiSEES to come on board. They would have wanted to collect a franchise fee. They would have wanted to use the risk-free money that came from the Small Business Administration to expand the influence of their brand.

And the Huntington Learning Center franchiSOR didn’t have anything to worry about because it was the franchiSEES’ who signed their names on the dotted lines and it was the taxpayer who paid loan guarantees at the time of default. The Huntington Learning Center franchiSOR didn’t ever have anything to lose by selling franchises and referring new franchiSEES to Banco Popular.

The audit report tells us what, specifically, Banco Popular did wrong. “The lender,” it says, “accepted unrealistic projected annual revenue figures that ranged from $483,000 to $650,025 as a basis for demonstrating the ability of the HLC franchises to repay their debts.” In other words, Banco Popular “backed into” the numbers. The bank decided what projected revenue numbers would justify underwriting the loans and then they pretended those numbers were realistic.

And it’s not as if Banco Popular didn’t have access to the information they needed to make a better decision. Nope. The audit report states that the “lender disregarded relevant and available data, which indicated that the franchises’ revenue projections were unreasonable.”

The audit report then states a common justification for the lender’s extreme neglect. It says that Banco Popular disregarded the “relevant and available data” “due, at least in part, to the lender’s perception that franchise loans required a lesser degree of due diligence because of the established business model of franchise systems.” In other wards, the franchise industry has successfully maintained a higher public reputation than it deserves. Franchised businesses are considered “established” regardless of revenue data and success rates.

Let me emphasize that the audit report states that if the lender had followed the SBA Standard Operating Procedures and “use[d] and assess[ed] the feasibility of realistic projections, the 12 loans should have been declined.”

And for the purpose of emphasis, let me again state that if the banks had done their job correctly, the 12 franchiSEES would have been spared the extreme misery that comes with making expensive investments based on bad numbers. And taxpayers would have been spared the burden of guaranteeing the bad loans.

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Screenshot from audit report

Yup. The SBA Office of the Inspector General found that the “Agency paid $2.1 million to honor its guaranties on the 10 defaulted loans.”

That’s 2.1 million dollars in loans that should never have been written guaranteed by the taxpayer and franchiSEES. That’s 2.1 million dollars invested into the Huntington Learning Center franchiSOR and the economy by people who should never have signed the loan documents in the first place. And, since the SBA had “paid $2.1 million to honor the guaranteed loans,” that was a $2.1 million dollar loss to the taxpayer.

And that’s just for the Huntington Learning Center loans underwritten by Banco Popular in 2007.

The problem is much bigger than one lender and one franchise.

Lenders have no incentive to follow SBA rules

Worst of all, the banks don’t have any reason follow the SBA Standard Operating Procedures. It’s a no-risk situation for them. Sure, the loans will default… but why should they care? The taxpayer has their back. Money goes from the taxpayer to the SBA to them…. consequence free.

The deal is risk-free for the franchiSORS and risk-free for the lenders. The franchiSEES lose everything they own and the banks benefit from making the loans.

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