Questions. We get questions. Some easy. Some not. One of the most frequent deals with Eligible Passive Companies (EPCs) and Operating Companies (OCs.) In addition to questions about the maximum rent an EPC may charge an OC (it may not exceed payments on the project debt, taxes, insurance and routine maintenance), lenders ask about whether an EPC may engage in any business activity other than as the holding company for an OC.

Of course: “No.” (SOP 50 10 5 (K), (Subpart B, Chapter 2, III. Pg. 124 and Subpart C. Chapter 2, III, pg. 306; and SOP 50 10 6 pg. 135) And it’s been “no” since shortly before SBA issued SOP 50 10 5 (K). But then you say, “SBA approved a deal for us a few months ago where the EPC was engaged in other activity.” At that point I can only say, “I know. That sometimes happens. But that loan was not compliant.”

Eligible or Ineligible? Some case studies:   

Case #1. An EPC owns three locations, leases two of them to the same OC and the third to another OC. So the EPC engages in more than one economic activity: Ineligible.

Case #2. The EPC owns commercial real estate and leases it to two different OCs. Ineligible

Case #3. The EPC owns commercial real estate as well as residential real estate. Ineligible.

Get the picture? In each case the EPC does something other than lease real estate to an Operating Company. And that makes it ineligible.

What’s the Penalty? The penalty for violating this provision no longer has you running down Main Street kicking and screaming. But it is serious. Here’s what the SOP says:

“…(T)he EPC and the OC must comply with all the conditions in 13 CFR § 120.111 and each condition is interpreted strictly. If all conditions aren’t 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.”

Wow. Fraud. Negligence. Misrepresentation. You know the rule is really serious when it uses three words to describe the same reality (like “right, title, interest” or “grant, bargain and convey”).

Bottom line: Don’t do it. Don’t let your EPC engage in any business activity other than leasing property to an OC.

Keep those questions coming! And stay safe.

Richard Jeffrey

Senior Associate, CDC/504 Programs