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Due Diligence Tips for SBA Lenders: 504 Loans

Due diligence requirements and efforts on SBA 504 loans are similar to those used when financing SBA 7(a) and non-SBA commercial loans.  For example, prior to the closing, among other matters, the Lender must ensure that all required insurance is in place; the borrowing and, if applicable, guarantying entities are all properly organized; and that no intervening liens exist concerning Lender’s priority on the collateral for the loan.   Frequently, Lender’s legal counsel is involved in handling many of these due diligence efforts on Lender’s behalf.   When participating in an SBA 504 Loan project, however, there are several additional areas that require following a different practice. 

  • Because lending under the SBA 504 program is for financing hard assets  – real estate or machinery and equipment with a useful life of ten or more years – the Lender must ensure that the use of Loan proceeds does not include ineligible items (unless specifically permitted under current SBA regulations) such as debt refinance, working capital, short-term machinery and equipment, or inventory.  Some of these items would be eligible under the SBA 7(a) loan program.
  • As with the SBA 7(a) program, the Lender must strictly comply with the requirements of an SBA Loan Authorization.  The SBA 504 Authorization is very different than the SBA 7(a), however.  Similar to the SBA 7(a) Authorization, the SBA 504 Authorization advises the Lender about the borrowing and guarantying entities, the uses of the Loan proceeds, the collateral required for the Loan, and other pre-closing conditions.  But the SBA 504 Authorization also provides the terms and conditions which must be satisfied for the debenture…the essence of the SBA 504 loan….to be sold, the proceeds of which will be used to satisfy the Lender’s interim (or bridge) loan.   The SBA 504 Authorization also describes the certified development company (CDC) and provides several conditions and requirements with which Lender and the CDC must comply in order for the SBA loan to be closed and the debenture sold.  Accordingly, to be most effective in closing its loans and the SBA 504 Loan, the Lender will need to work closely with the CDC to make sure the structure of Lender’s loans are consistent with the SBA 504 Authorization’s requirements and the CDC’s understanding of the SBA Loan and the subject Project.
  • Among other SBA 504 Authorization terms and conditions is that, at the closing of the SBA loan, the Lender of the permanent first position loan must execute a Third Party Lender Agreement (“TPLA”) certifying that its first position loan is fully advanced.  In the TPLA, the Lender will (a) confirm that it agrees to waive certain provisions in its loan documents that conflict with CDC or SBA requirements; and (b) covenant to subordinate prepayment penalties and late fees, to waive provisions prohibiting further encumbrances, and to provide written notice of default to both the CDC and the SBA.
  • Similarly, the interim (or bridge) lender must also provide the CDC at the closing of the 504 loan with special certifications and representations including (a) the amount disbursed on the interim loan; (b) that the disbursement of such loan was made in compliance with the 504 SBA Authorization; and (c) that it has no knowledge of any unremedied adverse changes since loan application submission.  The interim lender must satisfy its lien/security interests upon funding of the debenture.  Further, as the debenture typically only repays the principal balance of the interim loan, the interim lender must agree to collect all interest from the borrower separately.
  • Because a primary objective of the Lender in participating in an SBA 504 Loan is the repayment of the Lender’s interim loan, which requires that the SBA loan close and the debenture be sold, the Lender must diligently take all steps required to insure that the CDC will have what the CDC requires before the debenture is submitted for sale.  As the CDC and the permanent lender (and the interim lender, if different than the permanent lender) have many of the same due diligence requirements, it is imperative and in the best interests of all of the parties that the Lender and the CDC establish excellent communication early in the due diligence process to ensure that all pre-closing requirements are satisfied. The Lender and the CDC should use checklists to share information and due diligence materials that each has collected, which also saves everyone time and expenses for the borrower. 
  • Whenever possible, particularly on non-construction SBA 504 loans, try to schedule simultaneous closings of the term loan, the interim loan, and the SBA loan.  However, when a simultaneous closing is not possible, then obtain certifications from the CDC that all requirements of the SBA 504 Authorization have been met and that the CDC knows of no reason why the debenture will not be sold.   If the situation warrants, obtain a comfort letter from the CDC that details any open items and how and when such item(s) will be resolved.

To summarize, like with SBA 7(a) lending, best practice is for the Lender to comply fully with the SBA Authorization and thoroughly perform all required and sensible due diligence.  In doing so, the Lender should coordinate its efforts with the CDC.   It is recommended that the Lender not schedule closings until all of the CDC’s requirements have been satisfied.  By working closely with the CDC, lenders will ensure a smooth and proper closing process for itself, the CDC and, importantly, the borrower.

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