Typically, any small business applicant seeking SBA financing must be an active operating company. One exception to this general rule pertains to Eligible Passive Companies. The Eligible Passive Company (EPC) Rule is set forth in 13 CFR § 120.111, and is a narrowly construed exception to SBA regulations that prohibit financing assets which are held for passive income. Because it is an exception to SBA policy, the key to EPC eligibility lies in strict adherence to all EPC requirements as set forth in the CFR and the applicable SBA Standard Operating Procedure (SOP). If any one condition is not met, SBA may deny liability on the guaranty. This article will briefly discuss the key critical requirements of processing an SBA loan to an EPC.
First, SBA only permits one EPC per loan transaction. While there may be one or more operating company co-borrowers on a SBA guaranteed loan transaction; to be eligible, there can only be one EPC. For purposes of determining whether an applicant has one EPC or multiple EPCs, a lender must analyze the applicant’s legal form and ownership structure. A tenancy in common whereby multiple individuals or entities own or propose to own real estate as tenants in common is considered to be one EPC. Conversely, two or more passive entities that own separate real estate leased to one or more eligible operating companies is not eligible, as this structure contains multiple EPC applicants.
Secondly, the EPC must not collect rent from the operating company in excess of the proposed debt service, plus any additional rent necessary for maintenance, insurance, and property taxes. The EPC is a passive entity, and any rent in excess of the amounts needed to own the property would result in passive income, which is contrary to SBA’s lending requirements. Remember, the EPC Rule is an exception to SBA’s general requirement of extending financing to active operating businesses, and therefore the parties must ensure that they carefully comply with the rent restrictions set forth in the applicable SOP.
Similarly, an EPC cannot receive SBA loan proceeds in the form of working capital at closing. As stated above, an EPC is a passive entity. Lenders must exercise diligence in underwriting and allocating loan proceeds to ensure that either the loan amount does exceed an amount necessary to fund the proposed project, or alternatively that, the operating company be made a co-borrower, instead of a guarantor, on the loan to receive any loan proceeds allocated for working capital.
Finally, the EPC must lease 100% of the proposed real estate to the operating company. The lease must be co-terminus with the loan term, which may include options to renew, if necessary. The operating company is permitted to sublease a portion of the property so long as any applicable occupancy requirements as set forth in the SBA loan authorization are met. Lenders should properly document both a subordination of lease and assignment of leases and rents for EPC/OC transactions.
In addition to the requirements described in this article, there are additional caveats and conditions contained in the SOP related to the EPC Rule. Lenders must carefully review and comply with these guidelines to protect and preserve the SBA guaranty. For assistance with SBA compliance and loan closing matters, please contact Jen at 267.470.1206 or jborra@starfieldsmith.com.