Defaulted Loans to Franchisees of the Franchise Organization Resulted in $11 Million in Guarantee Payments, and Four Lenders Accounted for about 74 Percent of Defaulted Loans

Our analysis of SBA-guaranteed loans to franchisees of the franchise  organization approved from January 1, 2000, to December 31, 2011,  showed that SBA approved a total of about $38.4 million for 170 loans  made by 54 lenders. SBA’s guaranteed portion on these loans amounted  to around $28.8 million. SBA  made guarantee payments of around $11 million on the defaulted loans,  including about $8.5 million in guarantee payments on the 55 defaulted  loans from these four lenders. Of the 88 loans we reviewed from the four lenders, 55 (about 63 percent)  defaulted. In comparison, 19 of the 82 loans (23 percent) that originated  at the other 50 lenders to the franchisees defaulted. In addition, as part of our investigative work, we interviewed the owners of  22 franchisees of the franchise organization to obtain background  information on the SBA loan process and efforts to start their  businesses. In addition,  franchisees we interviewed noted difficulties meeting anticipated revenue  estimates, as well as limited access to information that would aid in  business planning. Alleged Loan Agent Fraud Could Not Be Conclusively Determined, and SBA Has Taken Initial Steps to Enhance Oversight of Loan Agents and Improve Loan Data Quality

We were unable to conclusively determine whether the loan agent  referred to us for investigation intentionally provided exaggerated revenue  projections to franchisees to help them qualify for SBA loans; however,  we found that first-year projected revenues on loan applications involving  the agent or her employer were, on average, more than twice the amount  of actual revenue for 19 of the 24 franchisees we reviewed in the first  year of operations. Results of Investigation of Alleged Fraud Were Inconclusive

As part of our investigative work, we examined an allegation that a  specific loan agent provided exaggerated revenue projections to some  franchisees of the franchise organization in our review to assist them in  qualifying for SBA-guaranteed loans. In an interview in February 2012, the loan agent told us  she obtained the revenue projections from her employer and former  clients, one of which she identified. The loan agent told us she provided  these revenue projections to clients. The employer and former client she  identified denied providing the revenue projections to the loan agent. SBA’s Office of Credit Risk Management debarred both the loan agent  and her employer, and they are ineligible to work with the federal  government for a period of 3 years beginning in January 2012. While the franchise organization can choose to  include earnings statements in the FDD, federal regulations do not  require franchise organizations to provide actual first-year average  revenues for start-up businesses in the disclosure document. Franchisees should include first-year revenue estimates in an SBA loan  application; however, this information is not necessarily available to  potential franchisees in the FDD and they may have to conduct due  diligence to identify this information from other sources, if available. Officials further stated that SBA has taken, and is  considering, other steps to enhance oversight of loan agents. In addition, officials noted SBA assesses the accuracy of  certain data fields when the lender submits a monthly loan status report  or loan files to request a guarantee payment, and an external auditor  reviews a sample of loans in LAS to validate that the financial data for the  loans are accurate.vendor to improve the consistency of franchise information in its database  by replacing SBA’s current franchise codes with publicly available  identifiers used in the franchise industry, and to verify the accuracy of  franchise information in LAS that lenders previously entered. However, we disagree with the representatives’ comments that our  comparison is potentially misleading and inaccurate. GAO staff who made major  contributions to this report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

This report describes (1) the magnitude of Small Business Administration  (SBA)-guaranteed loans to franchisees of the franchise organization, and  (2) the results of our investigation into the allegation, and aspects of  SBA’s oversight of its 7(a) loan program with respect to loans made to  franchisees of the franchise organization. We also  used the franchise organization’s revenue data to calculate average first- year revenues for a broader population of franchisees, and compared it to  average revenues reported in the franchise organization’s disclosure  documents. To better understand the franchisees’ experience with the 7(a)  loan program, we interviewed 14 additional franchisees of the select  franchise organization who received 19 SBA-guaranteed loans from one  of the four lenders with the highest loan volume and default rates. In  addition, on the basis of the 88 loan packages we reviewed for the four  lenders, we identified 24 franchisees that used the loan agent connected  to the allegation, or her employer, 19 of whom had data available to  compare the first-year revenue projections on their SBA loan applications  with the franchisees’ actual first-year revenue.
Why GAO Did This Study

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 about $1.5 billion, according to SBA. GAO was asked to examine SBAguaranteed loans to franchisees, and to investigate an allegation that a loan agent provided exaggerated revenue projections to franchisees of the same franchise organization to help them qualify for SBA loans.
This report describes (1) the magnitude of SBA-guaranteed loans to franchisees of the franchise organization, and (2) the results of GAO's investigation into the allegation, and aspects of SBA's oversight of its 7(a) loan program with respect to loans made to franchisees of the franchise organization.
GAO examined SBA's loan data and files of loans made to franchisees. GAO used the franchise organization's revenue data to compare to revenue projections in SBA applications, as well as revenue reported in the organization's disclosure documents. As part of the investigative work, GAO interviewed the franchisor, loan agents, and select borrowers to better understand the franchising experience.
GAO is not making any recommendations. In their comments, representatives of the franchise organization state that GAO's comparison of average revenue in the disclosure document and the first-year average revenue calculation is potentially misleading and inaccurate. GAO disagrees, as discussed in more detail in this report.

What GAO Found

Analysis of guaranteed loans to franchisees of a select franchise organization reviewed by GAO, approved from January 1, 2000, to December 31, 2011, showed the Small Business Administration (SBA) approved a total of about $38.4 million for 170 loans made by 54 lenders. SBA's guaranteed portion on these loans was approximately $28.8 million. Of the total population of 170 loans, 74 loans defaulted, 55 of which (74 percent) originated from four lenders that had the highest loan volume and default rates on loans to the franchisees. SBA made guarantee payments of around $11 million on the defaulted loans to franchisees, including about $8.5 million in guarantee payments on the 55 defaulted loans from these four lenders. Of the 88 loans reviewed from the four lenders, 55 (63 percent) defaulted. In comparison, 19 of the 82 loans (23 percent) that originated at the other 50 lenders to the franchisees defaulted. As part of GAO's investigative work, GAO interviewed the owners of 22 franchisees of the franchise organization in GAO's review, of which 16 defaulted on their loans and 10 filed for bankruptcy protection. Interviewed franchisees noted difficulties meeting anticipated revenue estimates and limited access to information that would aid in business planning.
GAO was unable to conclusively determine whether the loan agent referred to GAO for investigation intentionally provided exaggerated revenue projections to franchisees to help them qualify for SBA loans, and SBA has taken initial steps to enhance program oversight. The loan agent stated that she obtained the revenue projections from her employer and former clients, one of which she identified. She then provided these revenue projections to clients. The employer and former client she identified denied providing the revenue projections to the loan agent. SBA's Office of Credit Risk Management debarred the loan agent and her employer for encouraging false statements, among other things, making them ineligible to work with the federal government for a period of 3 years beginning in January 2012. According to GAO's analysis, the first-year projected revenues on loan applications involving the loan agent or her employer were, on average, more than twice the amount of actual first-year revenue for 19 of the 24 franchisees reviewed. Potential franchisees should include first-year revenue estimates in their SBA loan applications. However, this information is not necessarily available to potential franchisees in the franchise organization's disclosure document, which provides information about the organization's financial performance representations and franchisees' estimated initial investment, among other things. Further, federal regulations do not require franchise organizations to provide actual first-year average revenues for start-up businesses in their disclosure document. Thus, potential franchisees may have to conduct due diligence to identify this information from other sources, if available. GAO also identified discrepancies and other issues in SBA's franchise loan data with respect to fields used for risk-based oversight of its loans portfolio, such as default status, number of loans, and loan agent information. SBA has taken, or is considering steps, to address these issues and enhance oversight of loan agents. For instance, SBA is working with a third-party vendor to replace SBA's current franchise codes with publicly available identifiers used in the franchise industry. At the time of GAO's review, it was too early in the process to assess the effectiveness of these actions.