B-181432.OM, FEB 1, 1980

B-181432.OM: Feb 1, 1980

Additional Materials:

Contact:

Edda Emmanuelli Perez
(202) 512-2853
EmmanuelliPerezE@gao.gov

 

Office of Public Affairs
(202) 512-4800
youngc1@gao.gov

SEVERAL LEGAL QUESTIONS HAVE BEEN RAISED DURING THE COURSE OF THE REVIEW. SOME OF WHICH HAVE BEEN RESOLVED INFORMALLY BY ALAN N. THESE QUESTIONS AND OTHER RELATED INFORMATION ARE CONTAINED IN THE ATTACHMENT. IT IS OUR VIEW THAT SECTION 7(A) OF THE SMALL BUSINESS ACT. SECTION 7(A) PROVIDES THAT THE SBA CANNOT EXTEND FINANCIAL ASSISTANCE TO SMALL BUSINESS CONCERNS UNDER THAT SECTION UNLESS THE DESIRED CREDIT IS NOT OTHERWISE AVAILABLE ON REASONABLE TERMS FROM NON-FEDERAL SOURCES. WE BELIEVE THE CONTEXT IN WHICH THIS REQUIREMENT APPEARS IS OF SOME VALUE IN DETERMINING ITS PROBABLE MEANING. SECTION 7(A) OF THE SMALL BUSINESS ACT READS IN PERTINENT PART AS FOLLOWS: "THE ADMINISTRATION IS EMPOWERED TO MAKE LOANS TO ENABLE SMALL-BUSINESS CONCERNS *** TO FINANCE PLANT CONSTRUCTION.

B-181432.OM, FEB 1, 1980

PRECIS-UNAVAILABLE SUBJECT: LEGAL OPINION - EVALUATION OF SMALL BUSINESS ADMINISTRATION (SBA) POLICIES AND PRACTICES RELATED TO LOANS TO FRANCHISE BUSINESSES (CED 9 179) (CODE 077920)

ASSOCIATE GENERAL COUNSEL, OGC - JOHN J. HIGGINS:

ON FEBRUARY 13, 1979, WE RECEIVED A JOINT REQUEST FROM THE CHAIRMAN OF THE SUBCOMMITTEE ON COMMERCE, CONSUMER, AND MONETARY AFFAIRS, HOUSE COMMITTEE ON GOVERNMENT OPERATIONS, AND CONGRESSMAN TOBY MOFFETT, TO REVIEW THE SUBJECT POLICIES AND PRACTICES. SEVERAL LEGAL QUESTIONS HAVE BEEN RAISED DURING THE COURSE OF THE REVIEW, SOME OF WHICH HAVE BEEN RESOLVED INFORMALLY BY ALAN N. BELKIN OF YOUR STAFF. THE SUBCOMMITTEE STAFF, HOWEVER, RECENTLY RAISED TWO QUESTIONS CONCERNING INTERPRETATIONS OF LAW, FOR WHICH WE NEED YOUR WRITTEN OPINION. THESE QUESTIONS AND OTHER RELATED INFORMATION ARE CONTAINED IN THE ATTACHMENT.

INDORSEMENT

DIRECTOR, CED

RETURNED. IT IS OUR VIEW THAT SECTION 7(A) OF THE SMALL BUSINESS ACT, 15 U.S.C. SEC. 636(A) (1976), NEITHER REQUIRES THE SMALL BUSINESS ADMINISTRATION (SBA) TO, NOR PREVENTS IT FROM, ESTABLISHING A REGULATORY REQUIREMENT THAT FRANCHISEES MUST FIRST ATTEMPT TO OBTAIN FINANCING FROM FRANCHISORS BEFORE SEEKING ANY FINANCIAL ASSISTANCE FROM SBA.

SECTION 7(A) PROVIDES THAT THE SBA CANNOT EXTEND FINANCIAL ASSISTANCE TO SMALL BUSINESS CONCERNS UNDER THAT SECTION UNLESS THE DESIRED CREDIT IS NOT OTHERWISE AVAILABLE ON REASONABLE TERMS FROM NON-FEDERAL SOURCES. ALTHOUGH THE ACT DOES NOT SPECIFY WHAT ALTERNATE SOURCES OF FINANCING MUST BE EXHAUSTED BEFORE A BORROWER CAN BECOME ELIGIBLE FOR AN SBA LOAN, WE BELIEVE THE CONTEXT IN WHICH THIS REQUIREMENT APPEARS IS OF SOME VALUE IN DETERMINING ITS PROBABLE MEANING. IN THIS REGARD, SECTION 7(A) OF THE SMALL BUSINESS ACT READS IN PERTINENT PART AS FOLLOWS:

"THE ADMINISTRATION IS EMPOWERED TO MAKE LOANS TO ENABLE SMALL-BUSINESS CONCERNS *** TO FINANCE PLANT CONSTRUCTION, CONVERSION, OR EXPANSION, INCLUDING THE ACQUISITION OF LAND; OR TO FINANCE RESIDENTIAL OR COMMERCIAL CONSTRUCTION OR REHABILITATION, FOR SALE: PROVIDED, HOWEVER, THAT SUCH LOANS *** MAY BE MADE OR EFFECTED EITHER DIRECTLY OR IN COOPERATION WITH BANKS OR OTHER LENDING INSTITUTIONS THROUGH AGREEMENTS TO PARTICIPATE ON AN IMMEDIATE OR DEFERRED BASIS. THE FOREGOING POWERS SHALL BE SUBJECT, HOWEVER, TO THE FOLLOWING RESTRICTIONS AND LIMITATIONS:

(1) NO FINANCIAL ASSISTANCE SHALL BE EXTENDED PURSUANT TO THIS SUBSECTION UNLESS THE FINANCIAL ASSISTANCE APPLIED FOR IS NOT OTHERWISE AVAILABLE ON REASONABLE TERMS FROM NON-FEDERAL SOURCES.

(2) NO IMMEDIATE PARTICIPATION MAY BE PURCHASED UNLESS IT IS SHOWN THAT A DEFERRED PARTICIPATION IS NOT AVAILABLE; AND NO LOAN MAY BE MADE UNLESS IT IS SHOWN THAT A PARTICIPATION IS NOT AVAILABLE.

(3) IN AGREEMENTS TO PARTICIPATE IN LOANS ON A DEFERRED BASIS UNDER THIS SUBSECTION, SUCH PARTICIPATION BY THE ADMINISTRATION SHALL NOT BE IN EXCESS OF 90 PER CENTUM OF THE BALANCE OF THE LOAN OUTSTANDING AT THE TIME OF DISBURSEMENT. ***"

OUR INTERPRETATION OF THE RESTRICTION IN SECTION 7(A)(1), CONSIDERED IN THIS CONTEXT, SUGGESTS THAT CONGRESS WAS PRIMARILY CONCERNED THAT THE PROGRAM AUTHORIZED BY SECTION 7(A) NOT SUPPLANT OR REPLACE THOSE FORMS OF FINANCIAL AID TRADITIONALLY EXTENDED TO SMALL-BUSINESS CONCERNS BY BANKS AND OTHER LENDING INSTITUTIONS. ANALYSIS OF THE LEGISLATIVE HISTORY OF THE SMALL BUSINESS ACT TENDS TO SUPPORT THIS VIEW. WITH ONE EXCEPTION NOT HERE RELEVANT, THE LANGUAGE IN SECTION 7(A)(1) HAS NOT BEEN SUBSTANTIVELY AMENDED SINCE IT WAS FIRST ENACTED AS SEC. 207(A)(1) OF THE SMALL BUSINESS ACT OF 1953, P. L. 83-163, 67 STAT. 230, 236 APPROVED JULY 30, 1953. ITS REPORT ACCOMPANYING H.R. 5141, THE BILL ULTIMATELY ENACTED AS THE SMALL BUSINESS ACT OF 1953, THE HOUSE COMMITTEE ON BANKING CURRENCY EXPLAINED THE PURPOSE OF THE SMALL BUSINESS LOAN PROGRAM AS FOLLOWS:

"THE LOAN ASSISTANCE PROVIDED FOR IN THE ACT IS INTENDED TO SUPPLEMENT RATHER THAN BE COMPETITIVE WITH FINANCIAL ASSISTANCE EXTENDED TO SMALL BUSINESS BY PRIVATE FINANCING INSTITUTIONS. PROVISION IS MADE THAT LOANS CANNOT BE EXTENDED BY THE ADMINISTRATION UNLESS SUCH FINANCIAL ASSISTANCE IS NOT OTHERWISE AVAILABLE ON REASONABLE TERMS. TO FURTHER ENCOURAGE PRIVATE FINANCING INSTITUTIONS IN MEETING THE LOAN NEEDS OF SMALL BUSINESS, AUTHORITY WOULD BE GIVEN THE ADMINISTRATION TO PARTICIPATE WITH PRIVATE FINANCING INSTITUTIONS IN LOANS MADE TO SMALL BUSINESSES.

"THE COMMITTEE AMENDMENT WOULD ESTABLISH AN ORDER OF PROCEDURE TO BE FOLLOWED IN THE GRANTING OF FINANCIAL ASSISTANCE BY THE ADMINISTRATION. PRIVATE LENDING INSTITUTIONS, JUST AS THEY HAVE BEEN, WILL CONTINUE TO BE THE PRINCIPAL SOURCE OF CREDIT FOR SMALL BUSINESS. IF FINANCIAL ASSISTNCE IS DESIRED FROM THE ADMINISTRATION IN THE CASE OF A SPECIFIC LOAN IT FIRST WOULD HAVE TO CONSIDER THE ASSISTANCE IN TERMS OF A DEFERRED PARTICIPATION. IF IT IS SHOWN THAT A DEFERRED PARTICIPATION IS NOT AVAILABLE, THEN AN AGREEMENT COULD BE UNDERTAKEN FOR AN IMMEDIATE PARTICIPATION ON THE PART OF THE ADMINISTRATION. IF IT IS SHOWN THAT AN IMMEDIATE PARTICIPATION IS NOT AVAILABLE, THEN THE ADMINISTRATION COULD MAKE A LOAN TO THE SMALL BUSINESS CONCERN. THIS ORDER OF PROCEDURE IMPLEMENTS THE LOAN POLICY EXPRESSED IN THE ACT THAT LOANS SHALL NOT BE EXTENDED BY THE ADMINISTRATION UNLESS IT IS SHOWN THE FINANCIAL ASSISTANCE APPLIED FOR IS NOT OTHERWISE AVAILABLE ON REASONABLE TERMS." H.R. REP. NO. 494, 83D CONG., 1ST SESS. 6-7 (1953) CR. S. REP. NO. 604, 83D CONG., 1ST SESS. 2-3 (1953).

THIS DOES NOT MEAN THAT SBA COULD NOT HAVE REQUIRED FRANCHISEES TO SEEK FINANCING FROM FRANCHISORS BEFORE BEING CONSIDERED ELIGIBLE FOR FINANCIAL ASSISTANCE FROM SBA. THERE IS NOTHING IN SECTION 7(A)(1) WHICH LIMITS THE TERM "NON-FEDERAL SOURCES" TO "BANKS OR OTHER LENDING INSTITUTIONS" ONLY. ON THE OTHER HAND, THE ABSENCE OF SUCH LIMITING LANGUAGE IN THAT PROVISION DOES NOT MEAN THAT SBA MUST REQUIRE A PROSPECTIVE BORROWER TO EXHAUST EVERY OTHER CONCEIVABLE SOURCE OF FINANCING BEFORE BECOMING ELIGIBLE FOR AN SBA LOAN OR GUARANTEE. WE DO NOT BELIEVE THAT THIS WAS THE INTENDED EFFECT OF THE REQUIREMENT IN SECTION 7(A)(1) THAT BORROWERS SEEK FINANCIAL ASSISTANCE FROM "NON FEDERAL SOURCES" BEFORE APPLYING TO THE SBA.

TRADITIONALLY, IMPLEMENTATION OF SUCH A REQUIREMENT IS LEFT TO THE ADMINISTRATIVE DISCRETION OF THE AGENCY INVOLVED IN FULFILLING ITS STATUTORY RESPONSIBILITY. IN THIS CONNECTION, SECTION 5(B)(6) OF THE SMALL BUSINESS ACT, 15 U.S.C. SEC. 634(B)(6) SPECIFICALLY AUTHORIZES THE ADMINISTRATOR TO "MAKE SUCH RULES AND REGULATIONS AS HE DEEMS NECESSARY TO CARRY OUT THE AUTHORITY VESTED IN HIM BY OR PURSUANT TO THIS CHAPTER." PURSUANT TO THE ADMINISTRATOR'S AUTHORITY UNDER THIS SECTION, SBA ISSUED REGULATIONS SETTING FORTH THE BASIC PRINCIPLES "GOVERNING THE GRANTING AND DENIAL OF APPLICATIONS FOR FINANCIAL ASSISTANCE." 13 CFR SEC. 120.2 (1979). IN ADDITION TO REQUIRING APPLICANTS FOR FINANCIAL ASSISTANCE FROM SBA TO SUBMIT EVIDENCE DEMONSTRATING THAT THE APPLICANT HAD REQUESTED AND BEEN DENIED FINANCIAL ASSISTANCE FROM PRIVATE LENDING INSTITUTIONS, SECTION 120.2(B)(2) ALSO REQUIRES A SHOWING THAT THE FINANCIAL ASSISTANCE REQUIRED DOES NOT APPEAR TO BE OBTAINABLE IN ANY OF THE FOLLOWING WAYS:

(I) ON REASONABLE TERMS THROUGH THE PUBLIC OFFERING OR PRIVATE PLACING OF SECURITIES OF THE APPLICANT; (II) THROUGH THE DISPOSAL AT A FAIR PRICE OF ASSETS NOT REQUIRED BY THE APPLICANT IN THE CONDUCT OF ITS EXISTING BUSINESS OR NOT REASONABLY NECESSARY TO ITS POTENTIAL HEALTHY GROWTH; AND (III) WITHOUT UNDUE HARDSHIP THROUGH UTILIZATION OF THE PERSONAL CREDIT OR RESOURCES OF THE OWNER, PARTNERS, MANAGEMENT, OR PRINCIPAL SHAREHOLDERS OF THE APPLICANT; (IV) THROUGH OTHER APPLICABLE GOVERNMENT FINANCING."

WE BELIEVE THAT THESE REGULATIONS REPRESENT A REASONABLE ATTEMPT BY SBA TO IMPLEMENT THE STATUTORY RESTRICTION AGAINST PROVIDING FINANCIAL ASSISTANCE TO A BORROWER IF SUCH ASSISTANCE IS "OTHERWISE AVAILABLE ON REASONABLE TERMS FROM NON-FEDERAL SOURCES." AS INDICATED ABOVE, SBA COULD, IF IT CHOSE TO DO SO, HAVE ADOPTED REGULATIONS REQUIRING FRANCHISEES TO SEEK FINANCING FROM THEIR FRANCHISORS BUT IT WAS NOT REQUIRED TO DO SO. SBA DIRECTOR, OFFICE OF FINANCING, HAS INFORMALLY OFFERED SEVERAL REASONS WHY IN SBA'S VIEW, SUCH A REQUIREMENT WOULD BE IMPRACTICAL. IN THIS REGARD, WE SHOULD POINT OUT THAT OUR OFFICE HAS RECOGNIZED THE BROAD NATURE OF THE DISCRETION VESTED IN THE SBA UNDER SECTION 7(A) OF THE SMALL BUSINESS ACT ON A NUMBER OF OCCASIONS. B-14067 DECEMBER 3, 1974; 51 COMP.GEN. 474 (1972); AND B-140673 (OCTOBER 12, 1959).

THE MAJORITY OF SBA LOANS TO FRANCHISE BUSINESSES ARE MADE UNDER ITS 7(A) LOAN PROGRAM, AUTHORIZED BY SECTION 7(A) OF THE SMALL BUSINESS ACT. THIS SECTION OF THE ACT PROVIDES THAT SBA LOANS MAY BE MADE ONLY WHEN THE DESIRED CREDIT IS NOT AVAILABLE ON REASONABLE TERMS FROM NON FEDERAL SOURCES.

THE ACT IS SILENT AS TO WHAT IT CONSIDERS AS NON-FEDERAL SOURCES. HOWEVER, SBA REGULATIONS FOR THE 7(A) PROGRAM (13 C.F.R. 120 AND 122) STATE THAT GOVERNMENT ASSISTANCE SHOULD BE GIVEN ONLY AFTER ALL AVENUES FOR SOLVING A SMALL FIRMS FINANCIAL PROBLEMS HAVE BEEN EXPLORED, INCLUDING THE PERSONAL CREDIT OR RESOURCES OF THE OWNERS, PARTNERS, MANAGEMENT, OR PRINCIPAL SHAREHOLDERS OF THE APPLICANT. SBA'S REGULATIONS, HOWEVER, ARE SILENT AS TO WHETHER OTHER SOURCES OF CREDIT INCLUDE FRANCHISORS.

AS PART OF OUR REVIEW OF SBA'S FRANCHISE LOAN POLICIES AND PRACTICES, WE WERE ASKED TO ANSWER A NUMBER OF SPECIFIC QUESTIONS, INCLUDING THE FOLLOWING ONE:

"DOES SBA CONSIDER WHETHER THE FRANCHISOR IS FINANCIALLY CAPABLE OF FINANCING THE FRANCHISEE?"

WE LEARNED THAT SBA DOES NOT (1) CONSIDER WHETHER FRANCHISORS ARE FINANCIALLY CAPABLE OF FINANCING FRANCHISEES, AND (2) REQUIRE FRANCHISEES TO TRY TO OBTAIN LOANS FROM THE FRANCHISORS BEFORE ASKING SBA FOR LOANS. BECAUSE THE LAW IS NOT CLEAR ON THESE MATTERS, WE ARE RELUCTANT TO CONCLUDE IN OUR REPORT THAT SBA SHOULD REQUIRE FRANCHISEES TO SEEK FINANCING FROM FRANCHISORS. IT MAY BE POSSIBLE THAT SBA, BY NOT REQUIRING THIS, IS NOT TECHNICALLY ACTING AS A LENDER OF LAST RESORT, AS REQUIRED BY LAW.

WE CONVEYED THE FACT THAT SBA DOES NOT CONSIDER WHETHER FRANCHISORS ARE FINANCIALLY CAPABLE OF FINANCING FRANCHISEES TO THE SUBCOMMITTEE STAFF DURING A RECENT MEETING WITH THEM. AS A RESULT, THE FOLLOWING TWO QUESTIONS WERE RAISED, FOR WHICH WE NEED YOUR LEGAL OPINION.

1. DOES THE LAW PREVENT SBA FROM REQUIRING FRANCHISEES TO SEEK LOANS FROM FRANCHISORS AS A CONDITION FOR OBTAINING AN SBA LOAN?

2. DOES SBA HAVE THE AUTHORITY TO REQUIRE THIS?

SBA VIEWS

WE HAVE DISCUSSED WITH TWO SBA ATTORNEYS AND A PROGRAM OFFICIAL, SBA'S POSITION ON REQUIRING FRANCHISEES TO TRY TO OBTAIN LOANS FROM FRANCHISORS BEFORE ASKING SBA FOR LOANS. THESE OFFICIALS WERE AS FOLLOWS.

MR. JOSEPH MARKER, CHIEF COUNSEL FOR BUSINESS LOANS (653-3915)

MR. DONALD FARRELL, ASSOCIATE GENERAL COUNSEL (653-5505)

MR. ART ARMSTRONG, DIRECTOR, OFFICE OF FINANCING (653-5004)

MR. MARKER AND MR. FARRELL SAID THAT SBA DECIDES THAT FRANCHISEES ARE ELIGIBLE FOR SBA LOANS IF THEY HAVE THE RIGHT TO PROFIT AND BEAR THE RISK OF LOSS COMMENSURATE WITH OWNERSHIP. (THIS IS A POLICY DECISION.) THIS RIGHT IMPLIES THAT THERE IS NO AFFILIATION WITH THE FRANCHISOR, AND THE FRANCHISEE IS, THEREFORE, INDEPENDENT. (SBA CAN ONLY LEND TO INDEPENDENTLY OWNED AND OPERATED BUSINESSES). BECAUSE OF THIS REGULATION, MR. MARKER SAID THAT HE DOES NOT BELIEVE THAT SBA HAS ANY LEGAL BASIS FOR REQUIRING FRANCHISEES TO SEEK LOANS FROM FRANCHISORS AS A CONDITION FOR OBTAINING AN SBA LOAN.

MR. FARRELL ACKNOWLEDGED THAT THE SMALL BUSINESS ACT DOES NOT SPECIFY WHAT TYPES OF FINANCING ARE INCLUDED UNDER THE "OTHER SOURCES" PROVISION. FRANCHISORS, IN HIS OPINION, WOULD BE INCLUDED AS ANOTHER SOURCE TO THE EXTENT THAT WHEN THEY ARE WILLING TO MAKE LOANS SBA IS NOT ASKED TO.

MR. ARMSTRONG, HOWEVER, TOLD US THAT ALTHOUGH SBA CONSIDERS FRANCHISORS TO BE INCLUDED UNDER THE LAW'S "OTHER SOURCES" PROVISION, SBA DOES NOT REQUIRE FRANCHISEES TO TRY TO OBTAIN LOANS FROM THEM BECAUSE FRANCHISORS GENERALLY ARE NOT IN BUSINESS TO MAKE LOANS.