When federal agents swept into the offices of Patrick J. Harrington last January, they were on their way to cracking the largest loan fraud scandal in the history of the Small Business Administration.
Harrington, 44, then an executive vice president in the Detroit office of Business Loan Express (BLX), a subsidiary of Allied Capital, had bilked the SBA’s flagship 7(a) loan program out of at least $76 million, and perhaps as much as $96 million. One business magazine dubbed the caper “Cookie Jar Capitalism.”
But the sensational case didn’t end with Harrington’s arrest, or the indictment of 27 others, almost all from the Middle East. In the months since then, it has engulfed the SBA as well. The most bizarre twist involves an SBA attempt to suppress an investigative report on the fraud by its own Office of Inspector General (OIG).
The effort smacks of a cover-up, although SBA officials insist they were only attempting to protect sensitive information. But sensitive for whom? The report itself provides an answer. It details long-standing, widespread problems within the SBA that have enabled loan frauds costing taxpayers “hundreds of millions of dollars.”
Indeed, more than 60 OIG reports over the past five years have hammered the SBA about poor lender oversight and the potential for loan fraud. But in an outcome that’s all too familiar in light of the SBA’s Katrina disaster, the agency failed repeatedly to follow up on the recommendations. To the contrary, in the face of withering Bush administration budget cuts (reducing SBA staff by 25 percent), the agency delegated almost all oversight to the major lenders themselves, or third parties.
When problem loans did surface, OIG investigators found that preferred lenders, such as BLX, received favorable treatment. In addition, the report details a litany of other bureaucratic snarls from mismatched priorities and potential conflicts of interest, to a backlog of more than 4,000 unprocessed requests from lenders seeking SBA guarantees on defaulted loans. They date back anywhere from “12 months to over 6 years.”
Customarily, the OIG posts such reports on its Web site. But when this one was finished over the summer, SBA General Counsel Frank Borchert asked OIG to either withhold or substantially rewrite it. To his credit, Inspector General Eric M. Thorson and OIG’s own attorneys refused. The standoff ended with a compromise. Thorson allowed the General Counsel’s office to edit, or “redact,” the report.
Such requests are not out of the ordinary. Even though the OIG is supposed to be independent, the General Counsel’s office routinely reviews its reports, and sensitive legal, technical, or proprietary information is often redacted. In this case, however, the editing was so extensive, Thorson felt compelled to add a disclaimer on the cover, a first. Nearly all of OIG’s recommendations, for example, were blacked out.
The BLX fraud case, however, is “symptomatic of broader systemic issues that have restricted the effectiveness of SBA’s oversight,” Thorson testified.
For a number of years, BLX has been one of the most active lenders in SBA’s 7(a) loan guarantee program. Unlike most lenders, however, BLX was deemed a Small Business Lending Company (SBLC), which meant that the SBA regulated it exclusively. It also received the agency’s highest designation as a “preferred lender.”
“As such, BLX was allowed to originate and approve loans with virtually no prior SBA review,” Thorson said. “Although the fraudulent activity would not have been readily apparent to SBA, we believe that the high rate of defaulted loans and other indicators of problems with BLX’s loans presented undue financial risk to SBA and, therefore, merited in-depth reviews, as well as possible suspension of BLX’s [preferred] status.”
Yet the SBA continued to regularly renew its lending authority and honor the lender’s loan guarantee requests. In all, the SBA paid out $272.1 million to cover defaulted BLX loans between 2001 and 2006.
Debilitating staff cuts also took a toll on the agency at a time when its loan volume was skyrocketing. As a result, the SBA delegated more and more loan authority to lenders and reviewed only a “fraction” of those in the program. To complicate matters, the SBA consolidated the office with lender oversight duties under the same manager as the office that promotes loans, creating a clear conflict of interest.
The BLX scam should have been evident if the SBA had looked closely. For years, OIG investigations have revealed a pattern of fraud by loan packagers and other for-fee agents in the 7(a) program “that was evident in the BLX arrests,” Thorson noted. To date, however, agency efforts to track loan agents have been “limited and ineffectual.” As a result, “[packagers] are able to implement fraudulent schemes on multiple loans causing losses of millions or tens of millions of dollars,” Thorson said.
In testimony before the committee, SBA administrator Steven C. Preston seemed to minimize the problem. He noted that the agency oversees more than 5,000 lenders (640 are preferred). He said the agency has moved “swiftly” to recover losses in the BLX case and is in the process of implementing new rules on lending oversight. The redactions, he said, were necessary to strike a “delicate balance” between full disclosure and protecting the integrity of the agency as a financial regulator.
For his part, BLX Board Chairman Robert F. Tannenhauser told the committee his company would cover all of the government’s losses. “I want to be clear that any fraud in the loan process is unacceptable and is something we take very seriously,” he said.
While Tannenhauser’s promise is commendable, Preston’s assurances that the SBA will improve its track record are far less convincing. The clumsy attempt to suppress the OIG report has all the markings of the SBA’s cynical effort to clean up the huge backlog of Katrina loans that I reported in my column in July. Indeed, far too many questions still need to be answered before the SBA can declare an end to “Cookie Jar Capitalism.”