April 29, 2020
A Supplement to Our April 8, 2020 Article on PPP Loans and Affiliation Rules
On April 8, 2020, we published an article titled State of Play: Venture Backed Startups, the Paycheck Protection Program and the Affiliation Rule. In this article, we detailed interpretations of the affiliation rules governing the Paycheck Protection Program (the “PPP”). On April 23, 2020, the Small Business Administration (the “SBA”) and the Department of the Treasury issued a new FAQ 31 providing further guidance concerning the certification process for a PPP loan. This FAQ initially appeared to be a response to publicly traded companies like Shake Shack and Potbelly (who were exempted from the affiliation rules), receiving PPP loans. Media stories reported complaints by shut out applicants and others who believed that these types of entities have recourse to public markets for capital and did not have the same need for the PPP loans as privately held smaller businesses.
When the CARES Act was originally enacted, the SBA was explicit that the PPP program would not invoke the “Credit Elsewhere” test, a test used by SBA that requires lenders to certify that the borrower did not have the ability to satisfy its capital needs on reasonable terms and conditions from other sources.
New FAQ 31, set forth below, states that borrowers also have to evaluate the necessity of the PPP loan in light of their individual access to alternative financing, although the scope of the evaluation is ill-defined.
Question: Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?
Answer: In addition to reviewing applicable affiliation rules to determine eligibility, all borrowers must assess their economic need for a PPP loan under the standard established by the CARES Act and the PPP regulations at the time of the loan application. Although the CARES Act suspends the ordinary requirement that borrowers must be unable to obtain credit elsewhere (as defined in section 3(h) of the Small Business Act), borrowers still must certify in good faith that their PPP loan request is necessary. Specifically, before submitting a PPP application, all borrowers should review carefully the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. For example, it is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith, and such a company should be prepared to demonstrate to SBA, upon request, the basis for its certification.
Lenders may rely on a borrower’s certification regarding the necessity of the loan request. Any borrower that applied for a PPP loan prior to the issuance of this guidance and repays the loan in full by May 7, 2020 will be deemed by SBA to have made the required certification in good faith. (emphasis added).
The new guidance is vague and lacks definitions of key terms, such as “economic need,” “ability to access other sources of liquidity” and “significantly detrimental.” This is likely to cause confusion and uncertainty as borrowers may question whether they can make the certification in good faith. Without defined parameters, borrowers have to make judgments about whether their own situation is sufficiently dire and whether the terms of other sources of capital they have access to are sufficiently detrimental so that the required certification can be made in light of the new guidance. While the example cited in FAQ 31 was focused on a public company with substantial market value and access to capital markets, the FAQ did not limit its applicability to public companies, and indeed FAQ 37, issued on April 28, 2020, made clear that FAQ 31 applies to private companies as well. Also, on April 28, 2020, Secretary Mnuchin stated that the government would be auditing any borrower who took more than a $ 2 million PPP loan.
For those companies that have already received a PPP loan, a retroactive examination of whether they could have made the certification at the time they applied is strongly suggested by the FAQ’s reference to the safe harbor to return funds previously borrowed by May 7, 2020, which will then make the borrower’s previous certification be deemed to have been made in good faith. This seems particularly egregious since until FAQ 31 was published, the scope of review implied by available guidance did not reference the need to consider alternate sources of financing and indeed the elimination of the “credit elsewhere” test would have led applicants in the other direction. Rather the focus was on the business’s use of the capital to address COVID 19 related effects and maintaining employment for its workforce.
Boards of VC backed companies will need to consider how to evaluate situations where alternate financing is available. If, for example, a shareholder made an offer to fund the company but at a severe “down round” valuation, the board would have to consider whether the proposed financing is “significantly detrimental to the business” so as to allow it to make (or allow it to have previously made) the certification to apply for the PPP loan in good faith. One perspective may be to judge the terms of the alternative financing by what had been traditionally available to the company. It is critical to document the basis for making the certification in sufficient detail in case the determination is challenged.
We hope that additional guidance from Treasury/SBA will shed light on this. Until then, the Treasury/SBA has created additional uncertainty around the program and this may discourage cautious parties from risking liability if the Treasury/SBA disagrees with their judgment as to whether the borrower truly qualified for a PPP loan. One would expect that the “gray area” would not be where the Treasury/SBA will focus enforcement but the situation remains uncertain in the absence of additional guidance.
This article is current as of April 29, 2020 and reflects the state of the relevant laws, regulations, and guidance to that point. Any subsequently issued, legislation, rules, and guidance by Congress, the United States Treasury, the Small Business Administration and other various government agencies may change the information contained herein. While this article is meant as a useful resource concerning matters arising under the Paycheck Protection Program, it should not be considered legal advice for any specific situation.