Are You Confused Yet? The SBA Issues Supplemental Guidance on Paycheck Protection Program Implementation
On April 2, 2020, the U.S. Small Business Administration (SBA) released an interim final rule (the Initial Rule) announcing the SBA’s formal interpretation of the implementation of the Paycheck Protection Program (PPP), which was created by Sections 1102 and 1106 of the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act).
The SBA and the Department of Treasury have subsequently issued various forms of supplemental guidance on the implementation of the PPP, including an additional interim final rule regarding the application of certain affiliation rules (the Interim Affiliation Rule), a letter dated April 4, 2020 from the SBA’s Associate General Counsel for Procurement Law to SBA’s Office of Capital Access addressing size eligibility and affiliation rules under the CARES Act (the SBA Letter) and a “Frequently Asked Questions” document (the FAQ) posted to the Department of Treasury’s website, updated on an ongoing basis (last updated on April 8, 2020) (collectively, the Supplemental Guidance).
Additional guidance was widely anticipated, particularly in light of the Initial Rule’s suggestion that the SBA intended to publish further rules regarding the application of its usual affiliation rules for purposes of determining PPP eligibility. In particular, potential borrowers, such as venture capital- and growth equity-backed companies that would be ineligible under the usual affiliation rules that find affiliation based on “negative control” held by minority investors were hopeful the rules might be relaxed. Private equity-backed companies were also hoping for relief from the SBA from the affiliation rules. Unfortunately, however, the Supplemental Guidance only includes a narrow exemption from affiliation for faith-based religious organizations.
This alert outlines the key points concerning affiliation rules and other matters addressed in the Supplemental Guidance.
Broad Application of Affiliation Rules to PPP
The Interim Affiliation Rule confirms that, unless explicitly exempted by the CARES Act or the Interim Affiliation Rule, the affiliation rules and principles that are generally applicable to the SBA’s 7(a) program loans (see 13 CFR § 121.301) do apply for determining PPP eligibility.
Accordingly, most applicants must aggregate the employees (or revenues, depending on the size standard applicable to the principal affiliated business) of their affiliates for purposes of determining whether the applicant satisfies one of the following bases of eligibility for PPP:
- Qualifying as a “small business concern” under SBA’s existing industry-specific size standards (based on either number of employees or revenue);
- Qualifying as a “small business concern” under SBA’s alternative size standard which requires an applicant to have (i) a maximum tangible net worth not more than $15 million and (ii) average net income after federal income taxes for the prior two (2) full fiscal years is not more than $5 million (prior to the Supplemental Guidance, it was not clear whether this size test was applicable); or
- Meeting the supplemental 500-employee size standard added by the CARES Act, which provides that applicants are eligible if they employ not more than 500 employees. This supplemental standard applies regardless of whether an applicant qualifies as a small business concern under one of the two preceding standards.
The SBA Letter does, however, confirm the following limitations to the otherwise broad application of affiliation rules:
- The CARES Act rescinded a recent amendment to the affiliation rules and, as a result, the SBA will not use “common investment” or “economic dependence” as grounds for affiliation. By doing so, this at least narrows the affiliation analysis, which makes its application at least a bit less byzantine.
- Affiliation rules are waived entirely for entities that receive financial assistance from any company licensed as an SBIC (Small Business Investment Company). The waiver applies (i) regardless of the amount of investment from the SBIC, (ii) regardless of whether there are other non-SBIC investors and (iii) regardless of whether the financial assistance received from the SBIC is in the form of loans, debt with equity features, equity, guarantees and/or securities purchased from an underwriter. As a result, having a loan or equity investment from an SBIC, or potentially obtaining one before applying for a PPP loan, may enable an otherwise ineligible borrower become eligible.
Affiliation Due to Negative Control
The broad application of affiliation rules clarifies the questions over whether an applicant with minority investments from venture capital or other investment firms will be rendered ineligible for PPP due to the concept of negative control. The SBA Letter directly confirms that if the minority investor has certain consent rights that allow it to block actions deemed ordinary and essential to operating a company, affiliation rules will deem the minority investor to have the requisite “control” despite the lack of majority ownership.
Case law of the SBA Office of Hearings and Appeals have interpreted negative control to exist when a minority investor has the right to block the following types of actions:
- Making, declaring or paying distributions or dividends other than tax distributions;
- Establishing a quorum at a meeting of stockholders (and likely, by extension, at a meeting of the board);
- Approving or making changes to the company’s budget or approving capital expenditures outside the budget;
- Determining employee compensation;
- Hiring and firing officers and executives;
- Blocking changes in the company’s strategic direction;
- Establishing or amending an incentive or employee stock ownership plan;
- Incurring or guaranteeing debts or obligations;
- Initiating or defending a lawsuit;
- Entering into contracts or joint ventures; and/or
- Amending or terminating leases.
However, the Supplemental Guidance does make clear that if a minority investor in a potential applicant irrevocably waives or relinquishes any existing rights to block the foregoing types of actions, the minority investor will no longer be deemed an affiliate of the applicant. And, particularly since the SBA is not applying the common investment test, merely because an investor’s equity rights are available to a class of equity the borrower will not be affiliated with the investor unless that investor alone can exercise these rights.
Faith-Based Organization Exemption
The Interim Affiliation Rule exempts otherwise qualified faith-based organizations from the affiliation rules “where the application of the affiliation rules would substantially burden those organizations’ religious exercise.” The SBA noted that the exemption is necessitated by the potential for conflict with the Religious Freedom Restoration Act and the First Amendment.
Accordingly, the affiliation rules do not apply to the relationship between any church, convention of churches or other faith-based organization to any other person, group, organization or entity that is based on a sincere religious teaching or belief or otherwise constitutes a part of the exercise of religion. Faith-based organizations are permitted to rely on a good faith determination as to whether they are exempt from the affiliation rule and the SBA will not assess (or require lenders to assess) the reasonableness of such determination.
Employee Measurement Period
The SBA Letter clarifies that an applicant’s size is measured by calculating the average number of employees for each pay period in the preceding 12 calendar months. This eliminates the lingering questions as to whether employee size measuring should instead be based on the date of the PPP application or a calendar year 2019 average.
Borrower Responsibility for Affiliation Determination
The borrower is responsible for applying the affiliation rules as modified by the CARES Act and Interim Affiliation Rule and then certifying that it, when aggregated with its affiliates, is eligible to receive a PPP loan based on the applicable size standard. Lenders are not required to independently assess the affiliation determination and instead are permitted to rely on the borrower’s certification as to eligibility. There are potentially substantial penalties for certifying that a borrower is eligible when in fact it is not, so borrowers are advised to consult with their advisors regarding the affiliation rules before applying.
Lender Review of Payroll
The Initial Rule directs lenders to “[c]onfirm the dollar amount of average monthly payroll costs for the preceding calendar year by reviewing the payroll documentation submitted with the borrower’s application.” The FAQ clarifies that this does not require lenders to replicate the calculations. Borrowers are required to accurately calculate payroll costs and certify the accuracy of those calculations. Lenders are merely required a good faith review of the calculations and supporting documentation, the scope of which should be informed by the quality of the supporting documentation. Errors identified by the lender should be remedied with the borrower before submission to the SBA.
Lenders are permitted to use their own online portals and customized electronic application forms to collect information from borrowers, provided that such systems request the same information and certifications as required on SBA Form 2483.
Calculating Payroll Costs
The Supplemental Guidance clears up many questions that advisors and applicants alike have been grappling with in calculating payroll cost:
- Period of Time. Although the CARES Act provides that (except in the case of seasonal employers) payroll costs are to be calculated as the average monthly payroll costs “incurred during the 1-year period before the date on which the loan is made,” the FAQ indicates that borrowers “can calculate their aggregate payroll costs using date either from the previous 12 months or from calendar year 2019.”
- Independent Contractors. Payments to independent contractors should not be included in a borrower’s payroll costs.
- Federal Taxes. Payroll costs are calculated on a gross basis without regard to federal taxes imposed or withheld. As a result, payroll costs are not reduced by taxes imposed on an employee and required to be withheld by the employer, but the employer’s share of payroll taxes are excluded from payroll costs.
- $100,000 Compensation Limit. The CARES Act excludes employee compensation in excess of an annual salary of $100,000 from the meaning of “payroll costs.” The FAQ clarifies that this exclusion does not apply to non-cash employee benefits including employer contributions to retirement plans, payment for the provision of employee benefits, and payment of state and local taxes assessed on compensation. The exclusion applies only to cash compensation in excess of $100,000 annually.
- Third-Party Payroll Provider. In the case of borrowers that use third-party payroll providers to process payroll and report payroll taxes, payroll documentation from the third-party provider as to the amount of wages and payroll taxes reported by the payroll provider for the borrower’s employees is accepted payroll documentation for PPP.
The Supplemental Guidance makes clear that applicants are required to make the certifications below in its PPP application and is responsible for accurately determining affiliation and payroll costs (and the lender is able to rely on such certifications and determinations). Required borrower certifications cover the following items:
- The applicant has not and will not receive another PPP loan;
- The applicant was in operation on February 15, 2020 and had employees for whom it paid salaries and payroll taxes;
- Current economic uncertainty makes the PPP loan request necessary to support the ongoing operations of the applicant;
- The funds will be used for permitted purposes and the applicant may be legally liable for knowingly using funds for unauthorized purposes;
- Loan forgiveness will be provided for the sum of documented payroll costs, covered mortgage interest payments, covered rent payments and covered utilities, but not more than 25% of the forgiven amount may be for non-payroll costs;
- Documentation verifying the employee size (including, as applicable, any required affiliates) and payroll cost calculations will be provided to the lender;
- The information provided in the application and all supporting documents and forms is true and accurate in all material respects. Knowingly making false statements is punishable under the law; and
- Acknowledgement that the lender will confirm the eligible loan amount using tax documents the borrower has submitted, and attesting to such tax documents are identical to those submitted to the Internal Revenue Service.
Most of these certifications are now – finally – fairly straightforward. However, the Supplemental Guidance does not address the lingering questions about the certification as to the impact of current economic conditions on the applicant’s business. Some advisors have raised concerns that this certification may expose the applicant to risk of audit and possible liability in the future for improperly claiming that the funds are” necessary” for continued operations. While it is certainly possible that there could be spot audits in the future regarding whether a borrower needed the funds, the congressional intent underlying the PPP, however, is clearly to keep people employed until the economic uncertainty caused by the COVID-19 pandemic dissipates. And, since at the time of the application no one knows how long the worst of the crisis may last, almost every business is faced with the decision of preserving cash but reducing headcount. We think it is not likely that there will be “Monday Morning Quarterbacking” of whether obtaining the loan was necessary for the operation of the business at the time it was applied for (and we do point out that the loan application does not require the provision of any financial information such as financial statements or the like). Of course, if you have a business that has seen sales / profits spike as a result of the virus, you might think twice, but even then you don’t really have a crystal ball as to how circumstances might change in a month or two.
If you have questions or would like more information, please contact Ryan J. Udell (firstname.lastname@example.org; 215.864.7152), Adam Chelminiak (email@example.com; 215.864.7078) or another member of the Corporate and Securities Group.
As we continue to monitor the novel coronavirus (COVID-19), White and Williams lawyers are working collaboratively to stay current on developments and counsel clients through the various legal and business issues that may arise across a variety of sectors. Read all of the updates here.