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Who’s Accountable at the Government Accountability Office?

The Government Accountability Office (GAO) published a report in September 2013 reviewing SBA franchise loans, their failure rates and the causes of those defaults.  While I thank the GAO for its attempt, the true failure here is not of the loans themselves, but of this report. Three egregious errors made by the GAO include:  highlighting loan consultants as the main cause of the failures; spotlighting franchisees for their ‘lack of due diligence’ – while surreptitiously admitting the true information is nonexistent – hence the repeated references to “, if available”; and, the shameless omission by senior GAO officials of their own investigators’ report.  Other issues remain as well.

Full responsibility rests with financial institutions

The issue brought to the government focused on the banks’ responsibility to follow SBA Standard Operating Procedures (SOP’s) when underwriting SBA loans (multiple emails to the SBA’s Office of Inspector General {OIG} prove this).  Yet, the GAO claims that it was only asked to investigate a loan consultant who provided inflated revenue projections to franchisees.  Who was responsible for narrowly focusing this report as to make it worthless? Two investigations/audits performed by the SBA Office of Inspector General (OIG) culminated in the July 2011 Banco Popular (BP)/Huntington Learning Center report.  The OIG’s major finding?   None of the loans should have been approved and the bank’s failure to follow the SBA’s SOP’s voided all SBA guarantees and all guarantee money should be reclaimed. Currently, it is unclear what action, if any, the SBA took against BP regarding the loan guarantees. (OIG Report July 2011)

The GAO found that 28% of all SBA franchise loans underwritten between 2000 and 2011 required government guarantee payments without questioning how and why this occurred (the 28% payout is only after the SBA insurance pool is depleted - actual default rates are higher- some loans are paid off through the underlying loan collateral while others draw down the insurance pool).  The answer is provided in the July 2011 report proving that banks fail to follow SBA SOP’s thereby allowing approval of unqualified loan applications. 

However, the GAO report barely mentioned the lenders’ responsibilities:  “SBA relies on these lenders to ensure that borrowers meet the program’s eligibility requirements.” (pg 6 GAO report)  Yet, the July 2011 OIG report only briefly referenced ‘loan consultants’, instead finding the responsibility rested solely on the bank.  By ignoring the SOP’s (and the banks) the GAO provides complete cover to the banks/lenders enabling them to continue to ignore their legal (fiduciary) responsibilities to the SBA, the federal government and to taxpayers.  

The SOP’s require lenders to:  1. use historical financial data and; 2. perform a ‘reasonability analysis’ on the loan application proforma – the OIG found neither was done.  In addition:  3. SBA borrowers are required to submit annual P&L’s to their lender.  The importance of this ‘three-pronged’ approach cannot be overstated:  By obtaining annual P&L’s from the franchisees the bank now possesses ‘historical financial revenue data’ for that franchise system.  The banks are required to use that historical data to analyze future loan applications (proforma) for that system:  the “reasonability analysis”.  Proforma net profit must meet certain debt coverage ratios for loan approval and those revenue numbers must be based in reality.

Weak financial revenue will show in the annual P&L’s of the existing franchisees. 

“First year revenue projections on their SBA loan applications were 2.7 times the actual revenues the franchisees made in their first year of operations.” (pg 14 GAO Report) 

Thus, regardless of loan consultant participation, if the bank follows the SBA SOP’s, loan generation to specific franchise systems would cease due to the franchise’s proven inability to meet SBA lending guidelines.  It is not the loan consultant – it is the bank and the GAO failed miserably on this point.

Lastly, it is a franchisee’s net profit that determines SBA loan eligibility, not gross revenue – which makes this lending failure even more calamitous given franchise failure rates.

Lack of due diligence

The GAO investigator began his review in September 2011.  Numerous interviews of franchisees and the franchisor proved that real first year revenue numbers were unavailable.  This finding corroborated comments made by former Assistant Inspector General for Auditing for the SBA, Debra Ritt, back in 2010 who stated that if not for Huntington’s newsletter specifying first year annual revenue numbers for both 2006 and 2007, the SBA OIG would never have known the true data.  She admitted that first year revenue information for franchise systems is unavailable to the SBA.

The GAO’s repeated insistence on franchisee ‘due diligence’ is highly questionable due to their own findings.  It took an audit of the entire SBA loan portfolio for the Huntington franchise system for GAO to determine the true first year revenue.  Obviously, this is an exercise beyond the scope of any potential franchisee.

Please also note the GAO’s repeated reference to “if available” regarding franchisee due diligence of revenue performance.  Nuanced phrases in government reports have specific meaning.  The inability of the GAO, and the SBA, to obtain this information through public documents proves the ‘due diligence’ fallacy – and they admit to it by using “if available”.  This is apparently the GAO’s way of not offending the franchise industry – or their protectors in the U.S. Congress.  Adding insult to (financial) injury, the SBA, after repeated government reports proving its incompetence, now refuses to provide SBA franchise loan failure data – the only remaining public report shedding light on this well hidden fraud.

Where is the investigator's information?

Twenty two franchisees plus employees of the franchisor were interviewed.  Proof of the banks’ selling SBA loans into the marketplace after ripping numerous points out of the loan as pure profit was found, proof of franchisor knowledge that first year revenues generated over $100,000 in net losses was discovered and the banks possessed information that should have prevented approval of these loans.

Where is the report?  The investigators submitted it to GAO management.  Where is it? 

The GAO should release the investigators’ report, un-redacted, so all can see the actual findings.   Eighteen months of professional investigative work is missing.  The investigators appear to have been silenced and as with most government investigations it appears that what has not been released is the most important part of the story. 

In summary

Attempts were made throughout this report to minimize the veracity of the evidence and marginalize the complainants:

  1. The loan consultant is not the issue – the lenders are.  The SBA OIG understood the importance of the Standard Operating Procedures – something the GAO completely ignored.  The July 2011 report provided irrefutable proof that these SOP’s would have prevented the approval of these loans.  By purposely focusing on loan consultants rather than the banks this report tries to diminish the fraud.  Certain U.S. Senators unsuccessfully tried to kill this investigation early on.  Could this be the result? 

  2. Blaming due diligence ‘shortfalls’ on franchisees when the former SBA OIG’s Ass’t Insp. Gen’l and the GAO stated that first year numbers are unobtainable is disingenuous at best.  This is a backhanded attempt to redirect the reader’s attention to franchisees when, in fact, these investigative government reports prove that first year franchisee revenue information is completely inaccessible.

  3. GAO investigators scour the country for 18 months, uncover clear and unequivocal proof regarding the loan scheme and the report is quashed?  Is the GAO afraid of upsetting certain political figures and campaign contributors?

  4. With a 49% SBA loan failure for Huntington Learning Center and 22 franchisees interviewed, the GAO quotes the one franchisee fortunate enough to maintain working capital.  Releasing the comments of all the interviewees would be more professional.

  5. The most interesting attempt at minimizing the evidence was found in footnote 20 on page 12

“20The difficulties some of these franchisees faced may have been attributable to the economic downturn, given that the default dates for 12 of the 16 loans occurred from 2008 through 2010.”  The fact is:  The February 2008 newsletter published by Huntington clearly states the average first year new site franchisee gross revenues as $248,808 in 2006 and $262,272 in 2007. 

The GAO claims the economic downturn from 2008 – 2010 caused the defaults. How can that be? Huntington’s revenue numbers above are from 2006 and 2007.  U.S. GDP growth in 2006 was 5.12% and 4.42% in 2007:  Two strong growth years for the U.S economy.  Yet even in the good times Huntington’s first year average revenue was half of what is needed to meet SBA net profit requirements. These failures had little to do with the downturn.  Franchisees were expected to fail and the GAO knows this.  Had the banks performed according to the Standard Operating Procedures the loans would never have been approved.  The GAO’s overall analysis of this data is astonishingly inept.

 “Our intent was not to identify potential fraud or abuse for all franchise loans of the franchise organization, or the 7(a) loan program as a whole.”  (pg 5)

Just what was the GAO's intent?

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Jonathan Mack is an industry insider who has requested his name be kept anonymous.

Certain essays and writings from individuals are written from time to time under the pen name Jonathan Mack. These essayists have connected with Blue MauMau's editor to help vet their status as what they say they are or an insider. The editor feels that their insights and stories are important for the industry to understand or debate. The essay can simply tell their own story. Or, they can define problems in the industry. Since they are written under a pen name, these articles tend to heavily cite and hyperlink to authoritative sources to make their points. — Mr. Blue MauMau, editor