Most of us remember how, in 2009, Gordon Brown’s Labour administration sought to encourage lending to SMEs by the major UK banks. The initiative was christened “Project Merlin” and included, amongst other things, the Enterprise Finance Guarantee (EFG) Scheme.

In 2012 the coalition government widened the eligibility criteria to allow larger SMEs (with an annual turnover exceeding £20m) to apply for loans under the Scheme and this development crowned the lifting of several other restrictions, previously imposed under EU rules against state aid.

The banks have leapt to the assistance of thousands of SMEs and provided funding under the Scheme, in circumstances where they would not otherwise have done. It is believed that the UK benefited from the Scheme by as much as £1.1bn and the saving of some 18,000 jobs[1].

However, some of the SMEs that benefited from the Scheme have sought to avoid their repayment obligations to the banks. A common characteristic of those cases is that the SME alleges the bank "mis-sold" the EFG loan. Some banks have reviewed their EFG loans to investigate such allegations proactively.

Unfortunately it does appear that in many instances, both the bank and the SME were so keen to proceed that neither paid much attention to the rules of the Scheme. From the bank's viewpoint, there is a risk that the bank's representative did not explain the rules clearly to the SME and in some cases, may have misinformed the SME about the Scheme. Sometimes the SME came away thinking that it was the beneficiary of the government's guarantee, but that is incorrect.

The Scheme creates a tripartite arrangement between the bank, the SME and the government. The loan agreement between the bank and the SME provides that the latter pays the government a quarterly EFG premium of 2% of the capital balance on top of its loan repayments and, if the SME defaults on the loan, but the bank is unable to recover all of the debt, it may make a claim against the government guarantee.

The government's role is therefore to support the bank, not the SME, but this role has been misunderstood by SMEs and their advisers. In the event that the SME defaults, the bank is obliged to enforce the loan and recover as much money as possible from the SME in the usual way, but if it is unable to recover all of the debt it may make a claim to the government, which will then pay the unrecovered sum (provided it does not exceed 75% of the loan value).

It is perhaps ironic, given the Scheme's origins, that an SME which derived benefit from an EFG loan may refuse to repay the bank and expect it to charge the tax-payer instead. Arguably the politicians were over-eager participants in this saga too – in unprecedented times, perhaps their message left many feeling that they already understood the Scheme and had no need of the small print. The seismic events that prompted Merlin have faded into the past and hopefully misunderstandings about Merlin will disappear too.