SBA SOP 50 10 8.1, A.Ch2.A — Eligible Passive Companies

Chapter 2: Special Transaction Structures A. Eligible Passive Companies 13 CFR § 120.111 The Eligible Passive Company (EPC) Rule is an exception to SBA regulations that prohibit financing assets that are held for their passive income. (13 CFR § 120.130(d)) Because the EPC rule is an exception, the EPC and the OC must comply with all of the conditions in 13 CFR § 120.111 and each condition is interpreted strictly. If all conditions are not complied with, in the event of default on a 7(a) loan, SBA may deny liability on the guaranty. In 504, SBA may pursue a CDC Recovery Claim under 13 CFR § 120.938 in the case of fraud, negligence, or misrepresentation by the CDC. An Eligible Passive Company (EPC) must use loan proceeds only to acquire or lease, and/or improve or renovate, real or personal property (including eligible refinancing), that it leases to one or more Operating Companies (OCs) for conducting the OC's business, or to finance a change of ownership between the existing owners of the EPC. An EPC may only use loan proceeds to finance a change of ownership between existing owners of the EPC when the real estate or personal property has been held by the selling owner(s) for at least 36 months. For specific information on change of ownership loans with an EPC/OC structure:  For 7(a), see Appendix 15: 7(a) Changes of Ownership, and the eligible uses of proceeds section of each delivery method chapter. Note, change of ownership is not an eligible use of proceeds for the CAPLines and EWCP delivery methods, or for revolving facilities.  For 504, see Section C, Ch. 1, Para. C.13, Change of Ownership for the circumstances under which change of ownership is permitted. Note: See Para. C.13.a.iii. of such Section for important restrictions that apply if using a 504 loan to finance a change of ownership between existing owners of the EPC. With the exception of a change of ownership between existing owners of the EPC, an EPC may not use loan proceeds to acquire a business, acquire stock in a business or any intangible assets of a business, or to refinance debt that was incurred for those purposes. In addition, when the EPC and OC(s) are Co-Borrowers:  A 7(a) loan may include loan proceeds for working capital and/or the purchase of other assets, including intangible assets for the OC’s use; and  A 504 loan may include loan proceeds for the purchase of fixed assets to be owned by the OC(s). An EPC can take any legal form or ownership structure (e.g., corporation, partnership, LLC, sole proprietor, tenancy in common, etc.) A tenancy in common is a form of legal ownership and does not create a new or separate legal entity. There may be several individuals or entities in a tenancy in common, but the tenancy in common is considered one EPC. The loan documents must be signed by all of the members of the tenancy in common. Multiple OCs that are separately owned can participate in an EPC/OC structure, however, multiple EPCs in one transaction are not permitted. An EPC may own several unique properties that it leases to the same OC(s); however, in the case of multiple OCs, the same OCs (with the same ownership structure) must jointly occupy each property (i.e., it is not permissible for one OC to occupy one property and a different OC to occupy a different property). 1. Conditions that apply to all EPCs: a. The OC(s) must be an eligible small business; b. The proposed use of proceeds must be an eligible use as if the OC(s) were obtaining the financing directly; c. The EPC (with the exception of a trust) and the OC(s) each must be small under the appropriate size standard of 13 CFR Part 121; d. The EPC must lease the project property directly to the OC(s); and

i. Obtain a fully executed written lease;

ii. The lease must be subordinated to the SBA’s mortgage, trust deed lien, or security interest on the property (Note: This is not the same as a Landlord’s Waiver);

iii. The lease must have a term, including options to renew exercisable solely by the OC(s), at least equal to the term of the loan;

iv. The EPC (as landlord) must furnish as collateral for the loan an assignment of all rents paid under the lease. An assignment of the lease is only required when necessary to perfect the assignment of rents under applicable law, or to enable the SBA Lender to exercise the tenant’s rights upon default;

v. The rent or lease payments cannot exceed the amount necessary to make the loan payment to the Lender and an additional amount to cover the EPC’s direct expenses of holding the property, such as routine maintenance, utility expenses, insurance, and property taxes.

vi. For 504 loans, loan payments to the SBA, the Third Party Lender, and if applicable, to a lender authorized by SBA to provide the Borrower's contribution, are included in the calculation of “loan payment to the Lender.” Rent or lease payments cannot include amounts for accelerated payments on the Third Party Loan;

vii. When calculating repayment ability, the SBA Lender must consider whether the OC’s cash flow will be sufficient to cover the loan payment (for 504 loans, including the loan payment to the Third Party Lender), in addition to the expenses of holding the property including the payment of routine maintenance, property taxes, utility expenses, insurance, and all other ongoing expenses;

viii. The OC(s) must lease 100% of the property from the EPC, but it can sublease a portion of the property under the rules governing occupancy requirements with which all SBA Borrowers must comply (see Ch. 3, Para. C, Occupancy and Leasing Requirements of this Section for more information);