The 1997 audit report contained recommendations to improve the quality of purchase decisions and to establish a procedure to record repairs and report those results to the Office of Capital Access.

Regarding recommendations to seek recovery on the guarantees relating to Emergent Business Capital and Arkansas Capital Corporation , SBA is reviewing legal issues.

Private lenders are performing much of the loan underwriting, servicing, and liquidation functions which, until recently, were performed by SBA staff. To ensure compliance with SBA requirements, SBA must establish a better lender oversight program, improve its ability to identify lenders needing improvements in their performance, and ensure that borrowers comply with the terms of the loan agreement.

A recently completed audit (draft report issued) of Section 7(a) loan processing found that lenders did not consistently comply with 22 key processing procedures. Of

240 loans reviewed, 172 procedural deficiencies were noted for 120 loans. The deficiencies involved ineligible purpose of the loan, adverse change in financial condition not reported to SBA, lack of repayment ability, lack of capital injection, and use of proceeds for an unapproved or ineligible purpose. The audit results showed that 28 loans (12 percent) with guarantees totaling $3.7 million had deficiencies that could cause SBA to question part or all of the guarantee if a purchase request were received from a lender. Four of five non-compliances with SBA requirements occurred when SBA had limited or no oversight of lenders’ processing and disbursing actions. The non-compliances could be reduced by increasing lender oversight. According to SBA guidelines, District

Offices should have visited each lender annually unless a waiver was justified. Out of 147 lenders in our sample, only 33 (22 percent) received field visits by district personnel during FYs 1996 and 1997.

In July 1998, GAO reported that at five district offices visited SBA had not performed an on-site review of about 96 percent of the lenders in the past 5 years. Further, in some cases there was no evidence that lenders who had been SBA lenders for 25 or more years had received an on-site review. GAO concluded that SBA had no systematic means, without conducting periodic on-site reviews, to help ensure that lenders’ actions did not render loans ineligible, uncreditworthy, or uncollectible, thus increasing the risk of loss to the Agency. Lender monitoring is particularly important as SBA moves from direct involvement in loan approvals to increased reliance on participating lenders to perform loan origination, servicing, and liquidation.

SBA does not have a system to capture and summarize lender information to provide the Agency with adequate performance measurement data for loan monitoring. Information such as loan volume, loan origination quality, delinquency rates, default rates, and liquidations is not readily available. Collecting such information would allow SBA to identify lenders with potential problems and provide oversight to ensure that lenders’ actions are in the best interest of the Government.

FY 1999, SBA completed 10 reviews.

Small Business Lending Companies (SBLCs), like all Section 7(a) lenders, provide relatively high-risk, SBA-guaranteed loans to small businesses that meet eligibility criteria set by the Agency. Because they are not banking institutions, SBLCs are subject to review only by SBA. The Agency needs to ensure that its oversight process effectively monitors how the SBLCs administer their credit programs, identifies potential problems, and keeps SBA losses to a minimum. The Agency has initiated a comprehensive review process that provides the information required for oversight. SBA now needs to develop follow-up procedures to ensure that corrective actions are implemented in a systematic and timely manner.

Typical SBLC borrowers are companies that have insufficient credit history or collateral to qualify for conventional business loans. Of approximately 7,000 Section 7(a) lenders, 14 are currently SBLCs. In FY 1999, SBA approved 4,445 SBLC loans valued at $2.4 billion, which was 24 percent of the total value of all Section 7(a) loans approved that year.

SBLCs are not reviewed by the Federal and State regulatory agencies that monitor the safety and soundness of financial institutions. Three SBLCs have been audited by OIG over the past seven years, but, until recently, they were not reviewed on a regular, ongoing basis. In FY 1998, the Agency began a program of comprehensive annual examinations of each SBLC with the support of another Federal regulatory agency. The results of these reviews, combined with previous work by OIG and GAO, confirmed the need for additional internal controls and improved risk management in the SBLCs. The findings also emphasized the need for SBA to exercise more effective oversight of the SBLC program.

Reports

Significant Open Recommendations

The reports mentioned above are not OIG products; therefore, there are no open audit or inspection recommendations.

The Section 8(a) program provides significant contract support to a small number of the many eligible program participants. This occurs because SBA does not know the level of contract support, by industry, that is needed to overcome economic disadvantage nor does it have adequate procedures to preclude excessive contract awards. Consequently, some companies receive substantial benefits, while others receive little or none.

During FY 1998, when there were over 6,000 companies in the Section 8(a) program,

50 percent ($2.9 billion) of the dollar value of the contracts and modifications went to just 152 companies. (Section 8(a) contract modifications can be awarded to Section 8(a) companies after they leave the program.) One former company received over $140 million in Section 8(a) contract modifications during FY 1998.

Each of the top 10 companies (in terms of dollar value of Section 8(a) contracts and modifications) received an average of $56 million in Section 8(a) contracts and modifications in FY 1998. More than 3,000 Section 8(a) companies did not receive any contracts or modifications during the same period.

The purpose of the Section 8(a) program is to assist eligible small disadvantaged business concerns to compete in the American economy through business development. SBA has not determined how much contract support is required before a small disadvantaged business can compete in the American economy and, as such, has not determined an appropriate level of contract support that is needed to assist Section 8(a) companies.

Wealthy individuals are allowed to stay in the Section 8(a) program throughout a normal 9-year term of participation, contrary to the intent of the program. The Small Business Act requires that participants must be socially and economically disadvantaged, and it defines economic disadvantage as diminished capital and credit opportunities compared to owners of similar businesses that are not disadvantaged. SBA has not adequately determined the capital and credit opportunities available to non-disadvantaged owners. Further, a past evaluation found that many SBA employees did not have the ability to conduct these analyses. Therefore, participants may be allowed to continue to receive benefits even though they may not qualify for them, thus preventing those who do qualify from receiving benefits.

Section 8(a)(6)(A) of the Small Business Act states:

According to its regulations, SBA reviews various factors when considering diminished capital and credit opportunities: personal income, personal net worth, the fair market value of all assets, and a comparison of the financial condition of the company with other small businesses in the same primary industry classification. While SBA obtains information on a number of factors when determining economic disadvantage, it relies primarily on one criterion: net worth. Net worth by itself, however, does not show whether an individual has diminished capital and credit opportunities. Further, the net worth dollar levels to remain economically disadvantaged -- $750,000 after excluding the value of the business and the primary residence – place participants in the upper tenth percentile of wealth for American families owning businesses, according to statistics in the Survey of Consumer Finances, conducted by the Federal Reserve Board in 1992.

In a 1994 audit of 50 large Section 8(a) companies, OIG found that 35 of the 50 participants were millionaires. Nevertheless, they were still classified as "economically disadvantaged." OIG also reported that SBA employees making these reviews erred in making net worth determinations and that these employees "did not always have the skills and time needed to adequately analyze personal net worth."

The law requires that SBA consider assets when determining economic disadvantage; however, SBA has not determined the level of assets needed to overcome economic disadvantage. The 1994 audit found that SBA employees did not determine whether the participant accumulated excessive total assets.

A February 1996 SBA evaluation of annual reviews conducted by field staff raised questions about the ability of the field staff to conduct such analyses. The report noted that the staff’s financial analyses were very poor; staff members did not fully understand the concepts of economic disadvantage, financial condition of the firm, and access to capital; and the annual reviews contained few comparisons of the condition of Section 8(a) firms with similar businesses.

June 30, 2000.

There were 13 recommendations in the above report. Three recommendations still need to be implemented. These three recommendations concern

(1) modifying criteria used for determining one aspect of economic disadvantage,

(2) establishing a standard form for reporting net worth of Section 8(a) participants, and (3) establishing criteria for when these forms must be reviewed or compiled by an independent public accountant.

The Section 8(a) program is intended to be used exclusively for business development purposes to help small businesses owned by "socially" and "economically" disadvantaged persons compete on an equal basis in the mainstream of the American economy. To ensure that the business development aspects of the program accrue to its participants, SBA has rules to preclude a pass-through of a Federal contract to a non-participant; however, OIG audits have found that the rules are not enforced by SBA. As a result, many non-Section 8(a) companies benefit from the Section 8(a) program.

One rule limits the amount of a contract that can be subcontracted; however, the amount varies depending on the type of contract instrument used. For example, for service contracts, at least 50 percent of the cost of contract performance incurred for labor must be expended for employees of the Section 8(a) company. OIG auditors believe that excessive subcontracting is a common problem because determining labor cost is difficult and can be easily manipulated; therefore, little attention is given to the problem by Agency officials.

Another rule requires that supply contracts must either be filled by the manufacturer of the end item or by a company that meets SBA’s criteria for a "non-manufacturer."

In a June 1998 audit report, OIG recommended that the Associate Deputy Administrator for Government Contracting and Minority Enterprise Development (ADA/GC&MED) "provide definitive guidance and definitions to evaluate the manufacturing criteria at 13 CFR 121.406." The ADA/GC&MED agreed with the recommendation and stated that he planned to solicit comments from the business community and have specific discussions with businesses in computer-related industries. As of November 1999, SBA still had not clarified the manufacturing criteria.

Starting in 1997, SBA entered into Memoranda of Understanding (MOUs) with various agencies delegating Section 8(a) contract administration to those agencies. SBA should ensure that either SBA or the procuring agencies enforce the rules on excessive subcontracting and manufacturing.

Two of the four recommendations in the 1993 audit report still need to be implemented. One concerns complying with non-manufacturer provisions on Section 8(a) contracts, and the second concerns monitoring compliance with the work performance requirement on Section 8(a) contracts. The recommendation to provide definitive guidance and definitions to evaluate manufacturing criteria contained in the 1998 report also has not been implemented.

The Chief Financial Officers Act of 1990 requires agencies to develop and report cost information and systematically measure performance. In addition, reliable and relevant cost information is essential for measuring efficiency, which should be included in SBA’s performance goals under the Government Performance and Results Act (GPRA). In 1995, the Federal Accounting Standards Advisory Board (FASAB) issued a Federal Financial Accounting Standard on cost accounting which provides guidance for the development of cost accounting systems. The FASAB also urged Chief Financial Officers to give priority to implementing its requirements.

Historically, a major impediment to the implementation of cost accounting within the Federal government has been the reluctance of program managers to pay much attention to financial management or to accept cost accounting as a useful management tool. Under current cost cutting initiatives and the GPRA requirement for performance measurement, program-based cost accounting information would be an invaluable tool for evaluating program efficiency within SBA and measuring results.

The above report is not an OIG product; therefore, there are no open audit recommendations.

Challenge 8. Information system controls need improvement.

SBA programs and operations depend more and more on automated, often interconnected, systems and on electronic data rather than on manual processing and paper records. Current initiatives include paperless loan applications, use of digital signatures, expanded Internet access, and electronic data interchange. Reliable and accessible data is also essential for GPRA performance reporting. This increased reliance on automated systems has increased the risk of fraud, inappropriate disclosure of sensitive data, and disruption of critical operations and systems. To guard against such problems, SBA must take steps to understand its information security risks and implement policies and controls to reduce these risks.

For several years, SBA’s financial statement audits have identified weaknesses related to controls over the Agency’s automated information systems. The audit of SBA’s FY 1997 financial statements noted the following issues, and most were also present in the audit of SBA’s FY 1998 financial statements:

SBA has begun to implement OIG recommendations as described above.

Loan agents provide referral and loan application services to prospective borrowers or lenders for a fee. Some agents, particularly loan packagers, have been involved in a variety of fraudulent schemes, such as submitting false tax returns or other financial data, charging the borrower excessive fees, using fictitious names on SBA forms, exaggerating their ability to gain loan approval, acting in illegal collusion with officials of lending institutions, conspiring with borrowers to submit false loan packages, and performing other illegal acts. These schemes, which have been copied from one fraudulent agent to another, have resulted in loan purchases by SBA and, ultimately, the taxpayers.

In the 3-1/2 years ending June 30, 1999, in the Section 7(a) program alone, criminal investigations had been initiated on 60 individuals involving loan applications handled by 11 loan agents. The loan volume associated with these investigations exceeded $84 million. Allegations involving loan agents continue to be reported to OIG. Moreover, because the Internet allows everyone to reach a national audience, dishonest loan agents can expand the scope of their fraudulent activities. At the same time, the Agency may not have adequate staff to monitor loan agent activity.

To address concerns about some agents’ activities, SBA’s Committee on Loan Packager Reforms in 1996 recommended establishing a code of conduct, training curriculum, database of packagers, and improved disclosure of fees. Moreover, a March 1998 OIG inspection report identified efficient ways to reduce fraud by loan packagers and other loan agents. To avoid fraud, criminal background checks are needed on all loan agents. Legislation is needed to enable SBA to use social security numbers for background checks.

Loan Agents and the Section 7(a) Program, March 1998, Inspection Report # 98-03-01.

Final action on the first recommendations has not been completed because of the lack of statutory authority, as summarized above. Other actions to address the second recommendation are in process.

Borrowers who do not disclose past criminal histories have higher rates of default on SBA loans than those who either disclose their records or have no criminal histories. SBA does not have sufficient statutory authority to perform routine background checks. As a result, losses are higher than necessary.

Past OIG studies have revealed problems with the accuracy of the criminal history information provided by loan applicants on SBA’s Form 912, Statement of Personal History. To determine the extent of the problem, OIG initiated proactive investigations called Operations Cleansweep and Cleansweep II. Operation Cleansweep showed that almost 12 percent of the defaulted loans involved borrowers who failed to disclose their criminal records. A number of audits have also documented misrepresentation by borrowers of their criminal history. Most recently, an audit of 240 loans found that 8 percent of the 429 borrowers failed to disclose their criminal records.

After Cleansweep II, OIG estimated, based on lending at $11 billion per year, that the potential loss to the Government stemming from these false certifications could exceed $27 million. To avoid significant losses, criminal background checks are needed on all applicants.

Both the Congress and the Administrator have expressed support for a more rigorous check of an applicant's criminal history. The Small Business Reauthorization Act of 1997 (Public Law 105-135) authorized an expanded check on criminal histories of loan applicants. Subtitle D – Miscellaneous Provisions, Section 231, Subsection B, Background Checks, states that

While useful, the law does not require a criminal background check on every applicant. Unless an agency is granted a Special Purpose Code (SPC) allowing access for administrative purposes, the FBI's National Crime Information Center can be used to check on an applicant's criminal history only in support of a criminal investigation. To obtain an SPC, the requesting agency must have a legislative requirement. The language contained in Public Law 105-135 does not meet this test.

Verification of the criminal history of all business loan applicants would allow SBA to: (1) detect fraudulent applications early in the process, so they may be referred for appropriate criminal and/or civil action; (2) reduce the Government's losses by preventing fraudulent loans from being disbursed; and (3) provide a heightened level of deterrence through increased enforcement actions. The SBA OIG believes there is no other effective, efficient method available to achieve these goals while allowing for the uninterrupted flow of the loan process. OIG estimates that the start-up cost for initiating such a verification program would be approximately $1 million.

Final action has not been completed because of the lack of statutory authority, as summarized above.