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GAO: Substantial Franchise Failure Rates of SBA Guaranteed Loans

The Government Accountability Office (GAO) has just released a report examining a subset of the substantial defaults in Small Business Administration (SBA) guaranteed loans to franchisees. The general setting, which led to the narrow issue studied, is the massive failure of these SBA guaranteed franchise loans:

“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 $1.5 billion according to the SBA.” (GAO Report, p. 1).

The underlying problem leading to this study is stunning and massive on a government level. Twenty eight percent of these loans not only defaulted but also resulted in guarantee payouts from the coffers of the SBA. Our government paid $1.5 billion of these bad loans. Not stated is whether, and how many, other franchise loans defaulted but with no government payout due to other security covering the loans.

These substantial figures confirm a $10.6 billion dollar stimulus over the last decade for franchising from the government under the SBA 7(a) small business program lending program. Franchisors benefitted from the financing as did financial institutions which received guarantees that the SBA would cover defaulting loans. Banks received $1.5 billion from the government to cover defaulting loans, over 14% of the total amount of loans used to purchase franchises under the program. But what about the end result of this form of corporate welfare, namely the franchisees, recipients of the loans. The GAO report barely mentions the impact on franchisees:

“Default on an SBA loan may result in taxpayer loss, as well as potential hardship for the borrower, such as financial distress or bankruptcy.” (GAO Report, p. 2).

Those representing franchisees regularly recognize the understatement of the human misery caused by these failed franchise loans and businesses. Franchisees typically have their life savings in their franchise businesses and look to the businesses for their livelihoods. When the ship goes down all hands usually perish. And, according to the GAO Report, over twenty eight percent of the SBA guaranteed loans to franchisees failed.

The Narrow Study by the GAO of the Failure Results of SBA 7(a) Guaranteed Loans with One Franchisor and Four Lenders

No doubt due to the sheer volume of franchise loans, the GAO study addressed the failure results of four lenders with loans to one unidentified franchisor. Audits were made of the loans, and inquiries made to the franchisor, the lending institutions, agents, and franchisees.

For the unidentified franchisor the SBA guaranteed one hundred seventy franchisee loans totaling $38.4 million. Seventy-four of the loans went into default for which the SBA guaranteed portion of the loans was $28.8 million. The report further the loans made by four lenders which accounted for fifty-five of the seventy-four loan defaults.

The GAO Report Conclusions

What was your experience with SBA-backed 7(a) loans? What did your lender and banker use for your projected earnings in order to qualify for an SBA-backed loan?

The editor invites reader comments. Post here.

The GAO report determined that first year projected revenues in loan applications were more than twice the actual first year revenues of the majority of the franchisees.  (GAO Report, p. 1). The GAO recognizes that franchisee SBA loan applicants generally must include projected first year revenues in their loan application.

 But where is the franchisee to get this data? The GAO correctly finds that the FTC Franchise Disclosure Rule provides freedom to franchisors on what financial data to provide or whether to provide any financial information at all about franchise unit performance.  Thus, the GAO report concludes:

“potential franchisees may have to conduct due diligence to identify this information from other sources, if available.” (GAO Report, p. 1).

In an appendix, the GAO includes the unidentified franchisor’s statement that franchisees can gather further information by contacting existing franchisees or hiring business or financial advisers.  (GAO Report, p. 33).

The GAO interviewed one particular loan agent and her employer who were involved with multiple loans to determine whether revenues were exaggerated in the projections used to obtain the loans. As it is not a court, the GAO report stated that it was unable, however, to conclusively determine whether the loan agent intentionally misrepresented revenue projections. (GAO Report, p. 12).

While the GAO did not make any recommendations, the report notes that the SBA conducts risk based reviews of 7(a) program lenders. Such actions are more than important since the SBA often delegates loan approval, and with it the SBA loan guarantees, to a number of preferred lenders. These preferred lenders are given authority to approve the loans for which they will receive SBA guarantees without having the SBA review and approve the loans.  But another study, through the Office of Inspector General (OIG), concluded “that the SBA had not implemented a program or process to effectively monitor risk in its loan portfolio.”  Office of Inspector General Report 13-17, “The SBA’s Portfolio Risk Management Program Can Be Strengthened,” July 02, 2013, p. 3).  This earlier OIG report also contained another stunning finding:

Our limited analysis identified three high-volume franchises with historical default rates of at least 46-percent, default values over 38-percent and loss rates over 18-percent.  We determined that over the 2002-2009 period that we reviewed, the Agency disbursed nearly 1,000 loans to these three franchises, totaling $199 million.  Of these loans, 501, representing $84 million in Agency guaranties, defaulted.  (OIG Report 13-17, p. 3).

The Future of Franchising and the SBA 7(a) Guaranteed Loan Program

 The GAO Report should be sobering news for those concerned with franchising and with government efficiency. While not on the scale of real estate loan melt downs, with myriads of toxic loan portfolios emanating from liar loans, this report is alarming if nothing else for the in excess of twenty eight percent franchisee defaults on SBA loans. Each one of these defaults should be considered the economic death of the franchisee. Isn’t franchising touted as a tried and true system for those new to business?

A deeper analysis of these substantial loan failures in franchising should first consider the flawed financial disclosure under the current franchise disclosure system. Prospective franchisees typically want to know one important question: “How much will I make?” Banks, and the SBA as guarantor, should want to know this as well when making loans to franchisees. And all involved with these loans should insist on truthful and reliable financial information.

The current disclosure system, as the GAO Report correctly finds, does not require franchisors to provide any financial information to prospective franchisees. In other words the FTC Franchise Disclosure Rule allows a franchisor to provide nothing, or carefully parsed and limited, financial information in its Item 19 financial disclosures. See, 16 CFR Part 436.5.  In its report, the GAO determined that the projections submitted for most of one set of franchise loans overstated initial yearly revenue by one hundred percent from what actually occurred. (GAO Report, p 12). Can one really expect franchisees to gather such information not provided to them by the one entity which has the information, namely the franchisor which stands to benefit from the loan? Moreover, how is it that banks making these lending decisions get it wrong in such large percentages? Does the SBA loan guarantee program invite, if not encourage, such risky loans?

The second problem relating to the myriad franchise loan failures is much more subtle involving the franchise relationship itself. In the 1950s, the era of television series like Father Knows Best, lenders were not only conservative but they would first get to know the borrower. Is that missing today in franchise lending? In franchising there are two parties for a lender to get to know, the franchisee and the franchisor. While the franchisee is the borrower, the franchisor and its actions are critical to success for the franchisee and her ability to repay her loan. Franchisors can undertake actions that doom a franchisee to lose money or, in less drastic cases, cut into her profits. McDonald’s asserts that franchising is a three legged stool when it undertakes actions, with franchisor, franchisee, and customers all three being necessary to hold up the stool. But McDonald’s and other franchisors take actions under their contracts on an ongoing basis which directly affect the ability of their franchisees to be profitable and repay loans.

The unbalanced franchise relationship emanating from the one sided adhesion franchise agreements endemic to franchising constitutes the second problem regarding the franchise loan failures. This problem is not mentioned in the GAO Report, and apparently not on the SBA or the lenders’ radar screen in any meaningful way.

Does the SBA understand these contracts? If so, why does the SBA maintain a program of making loans involving franchise agreements which are systemically unfair exposing franchisees to detrimental risks at the hands of their franchisors?  Even well-known franchisors invoke these provisions, as there are few if any statutes to stop such opportunistic behavior. Why should a franchisor be able to put another franchise store next door to an already existing franchisee store? Why should a franchisor be able to make the franchisees purchase fungible products at higher prices from a vender which is giving the franchisor large and increasing rebates? Why should a franchisor be able to force national advertising of burgers or mega-meals at advertised prices which are below the cost of franchisees to produce?

While economists may debate the merits of such behavior, the results to franchisees can mean not just lost revenue but financial failure, inability to repay loans and loss of their family homes serving as collateral for the SBA guaranteed loans. But proposed loans to franchisees coupled with one sided agreements which authorize such franchisor behavior, should be denied by lenders and the SBA. The loan is not just to the franchisee, it includes the franchisor which controls the relationship under a franchise agreement. Just as it is not a good idea to not make loans to rebuild homes on a flood plain, so to with franchise loans using one-sided franchise agreements.

 Why is the endemic presence of inadequate financial information and outrageous unfair franchise contracts not addressed in the franchise acquisition lending process?  Perhaps it is because these loans are low risk to lenders:

“Because of the SBA’s backing of 7(a) loans, such loans are seen as relatively low-risk by lenders.”  Understanding and Utilizing the SBA Financing Process, IFA 46th Annual Legal Symposium (2013) p. 3.

Also is it because the SBA does not understand franchising and the risks franchisees face from their own franchisors?

 The one sided nature of franchising has led to calls for legislative protections, and the problems with franchise loan failure rates is only a portion of the problem. On the other hand franchisors should provide competent business models for which franchisees succeed to the benefit of all concerned. But some do not, and concerned franchisees, lenders and the SBA need to address these problems of inadequate financial disclosures and one sided adhesion contracts. 

GAO Report on SBA Franchise Loans1.32 MB
OIG: SBA's Portfolio Risk Management Program Can Be Strengthened808.36 KB
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About Peter Lagarias

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Attorney Peter Lagarias is a partner in Lagarias & Napell, LLP of San Rafael, California and represents franchisees and franchisee associations. He is a certified specialist in franchise and distribution law by the Office of Legal Specialization of the State Bar of California and frequent lecturer and writer on franchise law. He can be contacted by email or call (415) 460-0100.

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