B-140673, OCT. 12, 1959

B-140673, OCT. 12, 1959

TO HONORABLE WENDELL B. BARNES, ADMINISTRATOR, SMALL BUSINESS, ADMINISTRATION:

BY LETTER OF SEPTEMBER 3, 1959, ACKNOWLEDGED SEPTEMBER 22, YOU REQUESTED OUR ADVANCE DECISION AS TO THE LEGALITY OF CERTAIN PROCEDURES PROPOSED IN CONNECTION WITH LOANS TO SMALL BUSINESS CONCERNS UNDER SECTION 7 (A) OF THE SMALL BUSINESS ACT, 72 STAT. 387.

YOU POINT OUT THAT UNDER SECTION 7 (A) OF THE ACT, THE SMALL BUSINESS ADMINISTRATION (SBA) IS EMPOWERED TO MAKE LOANS TO SMALL BUSINESS CONCERNS IN COOPERATION WITH BANKS OR OTHER LENDING INSTITUTIONS THROUGH AGREEMENTS TO PARTICIPATE ON A DEFERRED BASIS. DEFERRED PARTICIPATION LOANS ARE THOSE MADE BY A BANK (OR OTHER LENDING INSTITUTION) UNDER AN AGREEMENT WHEREBY SBA AGREES, UPON NOTICE AND DEMAND BY THE BANK, TO PURCHASE AN AGREED PERCENTAGE OF THE UNPAID BALANCE OF A LOAN, PROVIDED THAT THE BANK HAS SUBSTANTIALLY COMPLIED WITH ALL THE PROVISIONS OF THE PARTICIPATION AGREEMENT.

YOU STATE IT IS TO THE GOVERNMENT'S ADVANTAGE TO HAVE LENDING INSTITUTIONS PROVIDE LOAN FUNDS, BUT THAT SOME DIFFICULTY HAS BEEN EXPERIENCED IN MAKING THE DEFERRED PARTICIPATION PROGRAM ATTRACTIVE TO NATIONAL BANKS; AND YOU BELIEVE THIS TO BE LARGELY BECAUSE OF THE NECESSITY FOR DETERMINING PRIOR TO PURCHASE THAT A PARTICIPATING INSTITUTION HAS COMPLIED SUBSTANTIALLY WITH THE PARTICIPATION AGREEMENT. YOU STATE FURTHER THAT UNDER THE PRESENT METHODS OF HANDLING DEFERRED PARTICIPATION LOANS, IF SBA FINDS THAT A BANK HAS FAILED TO COMPLY SUBSTANTIALLY WITH ANY MATERIAL REQUIREMENT OF THE PARTICIPATION AGREEMENTS, SBA IS UNDER NO LIABILITY TO PURCHASE ITS AGREED SHARE, THAT IF LIABILITY IS DENIED, IT IS POSSIBLE FOR THE PARTICIPATING BANK TO INCUR A SUBSTANTIAL LOSS ON A PARTICULAR LOAN WHERE SUCH LOSS IS NOT IN ANY WAY ATTRIBUTABLE TO THE ERRORS OF THE BANK; AND THAT FEAR OF SUCH A RESULT HAS LED TO CONSIDERABLE RELUCTANCE ON THE PART OF BANKS TO ENTER INTO THE PROGRAM.

APPARENTLY, SBA REVIEWS OF LOAN DOCUMENTS TO DETERMINE COMPLIANCE BY THE PARTICIPATING INSTITUTION--- IN, AS STATED, THE RELATIVELY FEW CASES WHERE DEMANDS FOR PURCHASE HAVE BEEN MADE--- REQUIRE MUCH LONGER THAN THE PARTICIPATING INSTITUTIONS DEEM REASONABLE; AND, AS A RESULT OF THIS DELAY, SBA'S REPUTATION FOR ADHERING TO THE TERMS OF ITS PARTICIPATION AGREEMENTS HAS BEEN SERIOUSLY JEOPARDIZED AND THE PERCENTAGE OF LOANS ON A DEFERRED BASIS HAS BEEN DECREASING.

IN ORDER TO REVERSE THE PRESENT ADVERSE TREND, YOU PROPOSE TO PURCHASE IMMEDIATELY UPON DEMAND SBA'S AGREED PORTION OF ANY DEFERRED PARTICIPATION LOAN WITHOUT REGARD TO THE FACT OF SUBSTANTIAL COMPLIANCE BY THE PARTICIPATING INSTITUTION. YOU WOULD, HOWEVER, RESERVE THE RIGHT TO RECOVER ANY LOSS OCCASIONED BY THE FAILURE OF THE PARTICIPATING INSTITUTION TO COMPLY SUBSTANTIALLY WITH THE PARTICIPATION AGREEMENT. ACCOMPLISH THIS, YOUR PARTICIPATION AGREEMENT WOULD BE REVISED TO PROVIDE THAT, NOTWITHSTANDING THE IMMEDIATE PURCHASE OF SBA'S AGREED SHARE OF A LOAN, THE PARTICIPATING INSTITUTION AGREES TO INDEMNIFY SBA FROM AND AGAINST DAMAGES, INJURY, AND EXPENSES WHICH SBA MAY IN ANY MANNER SUSTAIN BY REASON OF THE PARTICIPATING INSTITUTION'S FAILURE TO COMPLY SUBSTANTIALLY WITH THE TERMS AND CONDITIONS OF THE PARTICIPATION AGREEMENT AND THE LOAN AUTHORIZATION INCORPORATED THEREIN. THIS INDEMNIFICATION AGREEMENT WOULD BE IN ADDITION TO RECOVERY NOW PERMITTED UNDER THE TERMS OF YOUR PARTICIPATION AGREEMENT FOR GROSS NEGLIGENCE BY THE PARTICIPATING PARTIES. ALTHOUGH THE INDEMNIFICATION AGREEMENT WOULD PERMIT RECOVERY BY SBA ONLY AT THE TIME OF AN ACTUAL LOSS, YOU WOULD, AS SOON AS POSSIBLE AFTER PURCHASING YOUR AGREED PARTICIPATION IN A LOAN, CAUSE AN EXAMINATION TO BE MADE TO ASCERTAIN WHETHER THE LOAN WAS PROPERLY DISBURSED AND ADMINISTERED. IF ANY IMPROPER OMISSIONS OR COMMISSIONS WERE DISCLOSED BY YOUR EXAMINATION, THE PARTICIPATING INSTITUTION WOULD BE SO ADVISED AND PERMITTED THE OPPORTUNITY TO CORRECT THE DEFECTS IF CORRECTION WERE STILL POSSIBLE. OTHERWISE, ACTION TO OBTAIN RECOVERY WOULD BE INSTITUTED WHEN AN ACTUAL LOSS WAS INCURRED.

YOU POINT OUT THAT YOU REALIZE IT IS THE GENERAL POLICY OF THE GOVERNMENT TO DETERMINE COMPLIANCE BEFORE AUTHORIZING THE EXPENDITURE OF FUNDS, BUT YOU BELIEVE THAT IN THIS SITUATION WHERE THE BANKS ARE SUBJECT TO EXAMINATION ANY RISK IS GREATLY MINIMIZED. YOU POINT OUT FURTHER, THAT, IN ANY EVENT, YOUR PURCHASE WOULD NOT BE WITHOUT SOME FORM OF EVIDENCE OF COMPLIANCE INASMUCH AS YOU WOULD REQUIRE A CERTIFICATION BY THE PARTICIPATING BANK THAT IT HAD COMPLIED WITH THE PARTICIPATION AGREEMENT AND YOUR LOAN AUTHORIZATION; AND IN ADDITION, YOU WOULD REQUIRE THE BANK TO FURNISH YOU A COPY OF THE NOTE AS EVIDENCE THAT AN OBLIGATION HAD BEEN PROPERLY CREATED BETWEEN THE BANK AND THE BORROWER.

IN REQUESTING OUR OPINION AS TO THE LEGALITY OF THE ABOVE PROPOSED PROCEDURE YOU POINT OUT THAT IN ADDITION TO AUTHORITY UNDER SECTION 7 (A) OF THE SMALL BUSINESS ACT, AS AMENDED, SBA HAS AUTHORITY TO MAKE DISASTER LOANS ON A DEFERRED PARTICIPATING BASIS UNDER SECTION 7 (B) OF THE ACT AND SIMILAR LOANS TO DEVELOPMENT COMPANIES UNDER SECTION 502 OF THE SMALL BUSINESS INVESTMENT ACT OF 1958, 72 STAT. 697, AND THAT THE PROPOSED PROCEDURE IS CONTEMPLATED FOR LOANS UNDER EACH OF THESE SECTIONS.

SECTIONS 7 (A) AND 7 (B) OF THE SMALL BUSINESS ACT AND SECTION 502 OF THE SMALL BUSINESS INVESTMENT ACT EMPOWER SBA TO MAKE LOANS DIRECTLY OR IN COOPERATION WITH BANKS OR OTHER LENDING INSTITUTIONS THROUGH AGREEMENTS TO PARTICIPATE ON AN IMMEDIATE OR DEFERRED BASIS. THIS POWER TO MAKE LOANS IS BROAD AND VESTS IN THE ADMINISTRATOR CONSIDERABLE DISCRETION AS TO THE DETAILS FOR EXECUTING THE LOAN ARRANGEMENTS. CERTAIN LIMITATIONS ON SBA'S LOAN MAKING POWER ARE STATED IN THE VARIOUS SECTIONS; HOWEVER, EXCEPT FOR REQUIRING ADEQUATE SECURITY, THESE LIMITATIONS DO NOT AFFECT THE BASIS ON WHICH THE LOANS MAY BE MADE, BUT RELATE RATHER TO MONETARY LIMITATIONS AND THE CIRCUMSTANCES UNDER WHICH LOANS MAY NOT BE GRANTED. WE KNOW OF NO LEGAL PROHIBITION THAT WOULD PRECLUDE SBA FROM EXECUTING ITS DEFERRED PARTICIPATION LOAN PROGRAMS IN ACCORDANCE WITH THE PROCEDURES AS GENERALLY PROPOSED IN YOUR LETTER. HOWEVER, WHILE WE INTERPOSE NO LEGAL OBJECTION TO THE PROPOSED PROCEDURES, IT SHOULD BE UNDERSTOOD THAT WE ARE NOT THEREBY PRECLUDED FROM MAKING ANY RECOMMENDATION FOR CHANGE OF THE PROCEDURE AS OUR AUDIT OF SBA ACTIVITIES MIGHT DISCLOSE TO BE APPROPRIATE.

ONE SUGGESTION THAT OCCURS TO US AT THIS TIME WITHOUT BENEFIT OF DETAILED STUDY CONCERNS YOUR PROPOSAL TO WAIT UNTIL AN ACTUAL LOSS HAS BEEN INCURRED BEFORE INSTITUTING RECOVERY ACTION AGAINST AN INSTITUTION FROM WHICH SBA'S AGREED PORTION OF A LOAN HAS BEEN PURCHASED. SINCE YOU PROPOSE TO INSTITUTE SUCH RECOVERY ACTION ONLY WHERE THE LOSS INVOLVED IS ATTRIBUTABLE TO A FAILURE BY THE INSTITUTION TO ABIDE BY THE TERMS OF ITS PARTICIPATION AGREEMENT, IT WOULD APPEAR TO BE MORE IN INTEREST OF THE GOVERNMENT TO REQUIRE SUCH INSTITUTION, IMMEDIATELY UPON DISCOVERY THAT THE AGREEMENT WAS BREACHED, TO REPURCHASE AS ITS OWN A PORTION OF THE LOAN IN AN AMOUNT EQUAL TO ANY LOSS WHICH MAY ULTIMATELY BE ATTRIBUTABLE TO BREACH OF THE PARTICIPATION AGREEMENT. THE SITUATION SOUGHT TO BE CORRECTED WOULD THUS BE ALLEVIATED WITHOUT THE ADDED RISK TO THE GOVERNMENT OF FAILURE OF THE LENDING INSTITUTION.