Paycheck protection program summary.
A review of access to companies with funding from private markets.
The CARES Act established a $349 billion Paycheck Protection Program (“PPP”) at the Small Business Administration (“SBA”) to provide up to $10 million in streamlined loans to eligible small businesses, nonprofits, and individuals. The loans are 100 percent guaranteed by the SBA through 2020 and eligible for forgiveness depending, in part, on the use of loan proceeds for payroll and employee retention. Due to overwhelming demand, funding for the program ran out in less than two weeks, having approved over 1.6 million loans.
Last week, President Trump signed into law the Paycheck Protection Program and Health Care Enhancement Act, emergency legislation that will replenish the PPP with an additional $310 billion. While the SBA promptly reopened the program this morning, the issue still remains that SBA affiliation rules prohibit many businesses with outside equity investment from accessing PPP loans. Because the PPP is administered through the SBA, a business must meet SBA size standards based generally on a maximum 500-employee headcount or its particular industry’s standard. All affiliated companies to an individual business are aggregated against this threshold, which means that if a business has outside equity investors or owners, such as private equity or venture capital-backed companies, its employee count would include the total number of employees for all the portfolio companies of that particular fund.
Notably, the SBA last week issued an Interim Final Rule clarifying several issues around borrower eligibility. Among other things, it specifies that hedge funds and private equity firms are ineligible for PPP loans. Additionally, SBA reiterates that private-equity-owned businesses remain subject to the applicable affiliation rules, as would any business subject to outside ownership or control, but portfolio companies should “carefully review” the required good-faith certifications before applying for the program.
Applicable affiliation rules.
On April 3, the SBA released an Interim Final Rule on Affiliation (“IFR”) that clarifies the affiliation rules applicable to PPP applicants. Affiliation occurs when one entity controls or has the power to control the other, or when a third party (or parties) controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists. SBA’s supporting guidance outlines the circumstances that establish affiliation, mirroring the existing SBA regulations cited in the IFR.
- Affiliation based on ownership. An entity that owns or has the power to control more than 50% of the other entity’s voting equity. A minority shareholder is also deemed in control if it has the power to prevent a quorum or block action (often referred to as negative control) by the Board of Directors or shareholders.
- The FAQs (#6) provide that if a minority shareholder “irrevocably waives or relinquishes” those rights, they are no longer considered affiliated under this ownership test. While this is possible, it remains an open question as to how many fiduciaries can realistically avail themselves of this option.
- Affiliation arising under stock options, convertible securities, and agreements to merge. Stock options, convertible securities, and agreements to merge (including agreements in principle) have a present effect on an entity’s power to control the other. These rights are deemed to have been exercised.
- Affiliation based on management. The CEO or President of one entity also controls the management of another; an entity that controls the Board of Directors or management of one also controls the Board of Directors or management of another; or an entity controls the management of another through a management agreement.
Affiliation based on identity of interest. When close relatives have identical or substantially identical business or economic interests.
To put this in perspective, the rules could effectively apply the small business size threshold—500 employees or a business’ particular industry’s standard—across the entirety of a private equity fund’s portfolio. In addition, the FAQs (#4) make clear that it is the responsibility of the borrower, not the lender, to determine its affiliates and the applicability of affiliation rules. Lenders are permitted to rely on a borrower’s certifications.
Current limited waivers to affiliation.
While the SBA continues to count affiliates for the purposes of determining size eligibility, the CARES Act and subsequent guidance from the SBA and Treasury waive the affiliation rules for the following:
- Businesses in the hospitality and foodservice industries (assigned a NAICS code beginning with 72);
- Franchises identified by the SBA;
- Businesses who receive financial assistance from SBICs; and
- Faith-based organizations, if the relationship to one constitutes part of the exercise of religion.
In addition to the aforementioned waivers, the SBA’s Interim Final Rule released last week clarifies that a business participating in an employee stock ownership plan (ESOP) does not result in an affiliation between the business and the ESOP.
Current waivers to the affiliation rule may extend to some, but not all, companies with outside equity investment. We note that affiliation waivers do not mean a business is automatically eligible for PPP, but rather it no longer needs to determine the implications of affiliation when considering its eligibility for a loan.
Opportunities for relief.
The comment period for the IFR on Affiliation is open until May 15, which could provide an opportunity to write comment letters to pursue additional exemptions. This is part of the ongoing pressure on the Treasury Department and the SBA to broaden access to the program, such that further expansions of eligibility rules may be made through additional rulemakings or guidance. To provide a fix for small businesses backed by private equity or venture capital, the SBA and Treasury would need to amend the underlying regulations with a separate Interim Final Rule. In the absence of the SBA and Treasury exercising that administrative authority, Congress could get involved as further coronavirus stimulus packages are being negotiated.
The Federal Reserve’s two Main Street Lending Facilities, which were established on April 9 but have yet to be finalized, are additional opportunities for companies backed by private equity or venture capital. Treasury will provide $75 billion in equity using funds from the CARES Act, which the Federal Reserve will use to purchase a combined $600 billion in loans. The new facilities appear to promote broad access to small- and medium-sized businesses, but some loan terms may restrict portfolio companies from borrowing under the programs. Among the several issues we expect the Fed will need to address in forthcoming guidance, the calculation of EBITDA and related leverage restrictions will be important for companies backed by private equity or venture capital. Congress has additionally weighed in on the matter, with Rep. Eshoo (D-CA) last week leading a bipartisan group of 41 members in a letter to Chair Powell and Secretary Mnuchin. They specifically addressed the EBITDA limits in the context of startups and growth-stage businesses and urged for flexibility in updated loan terms. While the public comment period for the lending facilities closed on April 16, we expect the Federal Reserve has anticipated many of the comments they received, and are preparing to offer further clarifications shortly, even as further guidance could continue to come on a rolling basis.
In recent days, as PPP quickly ran out of money, press reports of large publicly traded companies receiving PPP loans considerably increased public scrutiny over the program. Criticism of what some labeled the “Shake Shack loophole” prompted Treasury to release updated FAQs (#31), reiterating that borrowers must make good-faith certifications that their loan request is necessary. While the guidance acknowledges that the CARES Act expressly waived the “credit elsewhere” requirement for the PPP, the new FAQ introduces the idea that borrowers must consider their current business activity and ability to access other sources of liquidity in making their good-faith certifications that current economic uncertainty makes a PPP loan necessary to support business operations. The FAQ specifically notes that public companies with “substantial market value and access to capital markets” are unlikely to be able to make that required certification in good faith and should be prepared to demonstrate to SBA the basis for its certification. Treasury adds that any PPP borrower that applied before the guidance will be deemed to have made the required good-faith certification if the full loan is repaid by May 7, 2020. In our view, Treasury has effectively introduced a new, ill-defined, credit-elsewhere test, which underscores the need for businesses to consider the capacity of the government to change the rules midstream.
Our bottom line.
We do not believe the Treasury and the SBA have addressed the PPP affiliation issue in a way that materially expands eligibility for small businesses that have taken outside equity investments beyond the waivers already provided for under statute and regulation. Affiliation can become a complex matter that requires companies to closely examine their governing documents on control interests or rights held by their investors. While there are ongoing efforts to expand eligibility through additional waivers to the PPP affiliation rules and broaden access to lending facilities, businesses receiving investment from private equity and venture capital are keenly aware of the oversight associated with receiving government funds.