We all know about the residential liar loans - no income and no asset. Not surprisingly these loans took on the nature of a gamble, benefitting only the originators who took out their fees early on.
Are there commercial liar loans - a loan based on projections of income that make no commercial sense? Is the practice widespread? If so, what is enabling it and how can we stop it?
In a very good three part investigation on SBA loan fraud, (the first part of the SBA loan fraud is here, and the second story on SBA liar loans is here, and the third part is forthcoming) Don Sniegowski, writes about the SBA liar loans as follows:
A major franchise lender, Banco Popular, has been rebuked by the Small Business Administration for participating in lending chicanery.
The censure has both the lending and franchise industries concerned that the investigation may spread beyond the Puerto Rico-based bank.
Bob Coleman, publisher of the Coleman Report for lenders and a consultant to small business bankers, thinks that the situation isn't limited to just Banco Popular.
Most lenders thought future projections were unimportant. "That was pretty much the whole industry that did it that way," he declares.
He thinks future financial estimates for a business were never a high priority for bankers in screening the viability of an SBA-guaranteed loan.
"Projections were seventeenth on the list," he emphasizes.
While one or two quotes from SBA authorities is not evidence of systemic failure, my personal view is that there is a good possibility of systemic SBA loan fraud. (I am not complaining that projections are bad, but rather that the mechanisms to rein in or eliminate bad projections are being avoided.)
Here are my reasons why:
1. No bank would lend against any business plan that could be constructed only out from the information in the franchisor's the item 19's claim and whatever local operational information is also available. (There is, by definition, no local information for a new store.) Remember by FTC and State Policy all the earnings information has to be in the Item 19 statement, except for local store information.
2. If an SBA loan is made then, there has to be "enhanced" earnings report given to the franchisee's bank by the franchisor. There are a number of consultants who will prepare this information, and they appear to be in a difficult conflict of interest being both the franchisor and franchisee's agent. That conflict of interest is unbearable if the consultant gives the enhanced earnings report directly to the bank with minimal franchisee involvement, oversight or review.
3. The current game, though, is that these enhanced earnings reports will be substantially prepared in advance or before closing, but only given to the franchisee in support of their loan application after the franchisee has signed an agreement.
In that agreement, the franchisee agrees that the franchisor did not give them any more earnings information than appeared in the item 19, and if the franchisors did so, then franchisee agrees not to rely upon it - despite the enhanced earnings report being prepared precisely so that the franchisee could get a SBA loan!
We could well be slipping down the slope into the worst feature of Russian culture.
"You lie, your listeners know this and you know that they don't believe you...and they also know that you know they don't believe you. Everybody knows everything. The very lie no longer aspires to deceive anyone. From being a means of fooling people it has for some reason turned into an everyday way of life, a customary and obligatory rule for living."
(Oddly, the current state regulators and state AG's find nothing in this practice to investigate despite all the predicate elements of a RICO fraud being in place.)
What is silly and pointless about this game, apparent from bringing a number of people uncomfortably close to a RICO claim, is that it is all a waste of time.
The franchisor should simply include the enhanced earnings report in the item 19 and avoid the entire problem - unless of course the expanded item 19 could not withstand scrutiny, and has to be rushed through in a pro forma manner.
From a game theoretic or strategic point of view, franchisors who do not include in the item 19 these enhanced earnings reports are signalling that these reports are inherently unreliable if given at a future date, after the closing.
The point here is simple. After the closing, there is no legal liability to be found in the disclosure document for the information given after the sale.
It is in the franchisor's strategic interest at that point to be "over enthusiastic" about the quality of future earnings. It will be difficult right after closing for the franchisee to call the franchisor a liar or worse. Bad projections will get accepted by both parties, which is bad for both of them - although much worse for the franchisee.
But the strategic franchisee who knows this can prepare a number of pre-closing responses to avoid being trapped. Waiting until after closing is not a good option, however.
The takeaway for a prospective franchisee is this: if the bank would not lend against a business plan constructed only from the Item 19 information, then any further information from the franchisor is inherently unreliable and dangerous.
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