Episode #6: PPP Loans and the Main Street Lending Program (Matt Swartz)

Joel Simon: We’ve been working closely together for quite a number of months, Matt. So let’s jump right into a topic that I know is near and dear: the SPA’s payroll protection laws. Everyone’s been focusing on the basis for applying for these loans, but not paying much attention to the practical implications down the road for a PPP borrower that might be sold in an M/A transaction prior to the loan’s maturity. What should people be thinking about here?

Matt Swartz: There has been a tremendous amount of attention among middle market companies and small companies to the process of applying for and in anticipation of potential forgiveness of the PPP loans. A number of companies are facing this question of having an acquisition offer prior to the maturity or even the application for forgiveness of these loans. The first thing to remember is that while we have been focused on the standards of the loan application—for example, the necessity standard—and the certifications that the borrower has to make in the application, it’s still a loan. It’s still a note and a loan agreement with the bank that includes covenants, and those covenants are likely to include a covenant against a sale or control of the company without the bank’s consent. When you have a violation of a covenant without the bank’s consent, you have a default. It’s a bit of a dramatic term to introduce here, but that’s a fact. So, remember it’s a loan. You’ve got to go to the bank and let them know you are on the verge of selling a controlling interest in the company. And if the bank won’t waive enforcement of that covenant, then there’s not a lot more discussion because the loan will have to be paid. If they will, then that’s another line in the flowchart: how should the borrower proceed in its dealings with the acquirer of the borrower?

One of the important features of the PPP loans is the restrictions on use. Those restrictions on use continue as long as the loan is outstanding—not merely during that first eight-week period, but the entire period that the loan is outstanding. Good contracts make good partners, just like good fences make good neighbors. You need to spell out what the obligations of the acquirer will be with respect to the use of the money that the company borrowed before it was sold. You—and that could be the CEO or majority owner—made the certification in the loan application, so you should take responsibility in the acquisition agreements to make sure that the company continues to follow the restrictions that applied when the money was borrowed.

Simon: Now, with COVID-19 …

Swartz: Now we’re veering into new territory. These kind of things are not what one normally thinks of as customary or market in M&A documents, but of course, so little is customary in the era of COVID-19. We’re getting used to a lot of changes, and I think one of them will be if there remains borrowed capital subject to a PPP loan, imposing obligations on the acquirer to follow the use restrictions. There are other dimensions to it, as well. One of them is working capital. Sometimes, very often, acquisition agreements include purchase price adjustments based on working capital balance of the target in an acquisition. A question that’s reasonable to ask would be: would you treat cash that’s borrowed with restrictions on its use the same as you would treat other cash in terms of working capital balance? Because one thing that one cannot do with borrowing cash is distribute it, use it for repurchases of stock. So the cash will either have to be repaid or stay inside the company and used for the purposes allowed and dedicated. So you need an obligation for the borrower to do that, and you need to decide how that cash will be protected and how it will be counted in a working capital determination. Just as you need to decide whether the loan itself is deemed to be indebted in the ordinary sense of the word. It probably should be since there’s a repayment obligation and also the cost of the loan—the interest rate—is much less than others available. So, financial advisors and others should work with the company to determine how that package should be combined to work effectively in the purchase agreement.

But I think the big mistake to avoid is not discussing it. The key objective to obtain is specifying exactly how the post-acquisition company will use the cash.

Simon: Those are very interesting issues and great insights, Matt. Actually, in discussing other topics on this podcast, one of the things that often has come up is the importance of companies being proactive rather than reactive, and we’ve given another example where talking about the issue upfront in advance rather than figuring out how to deal with it at the end is definitely the way to go.

Let’s turn briefly to the Main Street lending program, which also hasn’t been launched. There’s been a lot written about it, and the Fed is presumably revising and considering some issues that have been brought to their attention by different industry participants. This program is aimed at larger borrowers with larger government-backed loans contemplated. But I know there’s at least one significant issue in the existing Fed’s term sheets that makes the program ill-suited for a future sale of the borrower.

Swartz: There’s an evolving body of rules on all of these loans—one of the things we’ve learned is that the government is figuring this out as they go. I suppose that is to be preferred than waiting to make the money available. I think the main issue confronted by sellers that borrowed under the Main Street loan program would be the obligation to repay the debt borrowed under a Main Street loan prior to repayment of any other debt. Most acquisitions, not all, are consummated on what is called a cash-free/debt-free basis. That is, typically the purchaser does not want to acquire a company with its debt, and sellers don’t want to sell cash. Typically, buyers don’t want to buy cash, either, although that’s a different topic. So if a seller has multiple loans, including a Main Street loan, and the transaction is structured as a cash-free/debt-free transaction, the Main Street loan would have to be paid off first. That’s understandable from the government’s point of view, somewhat unfortunately for the borrower/seller’s point of view, because a low-interest loan would be a nice thing for the acquirer of the company to have. If that loan is mixed with others for the purpose of assessing the company’s whole loan exposure, there’s no choice but to pay off that low-interest loan first, which is of course, the opposite of the advice that borrowers normally get: pay off the highest interest first. This is the reverse, so unfortunately, it takes the favorable interest rate of a Main Street loan away from the borrower as an advantage it might be able to offer buyers in an acquisition.

Simon: That’s a good point, Matt. I know one other issue that is probably relevant in an acquisition context is that the Main Street loans have a requirement for the borrower to use commercially reasonable efforts to retain its employees and maintain its payroll. That seems like an issue that might be complicated or difficult to achieve in an asset sale context, for example. So if a company sells all or substantially all its assets, then ordinarily the employees may or may not move with the asset sale. But if the company has sold its assets, then the existing company likely doesn’t need all the employees anymore, and if the employees moved to the purchaser, I don’t know whether the Fed would see the purchaser as fulfilling the original borrower’s obligations on that front. So, it seems like there’s going to be further guidance coming from the Fed on some of these issues.

Swartz: Yes. We’re in a world of continuous guidance on these loans, and one thing to keep in mind with that is that sometimes the asset sale structure is chosen not because the buyer has less interest in the target’s employees, but because they don’t want to take on the liabilities of the seller. So the loan itself would be a liability, of course, which is another question, whether the bank involved would allow its obligation to be assumed by the buyer. Many times, it would in normal commercial transactions. A quick note, though—in M&A, we frequently negotiate the obligation of the buyer to continue to employ the seller’s employees at current compensation levels for a set period. So while that’s something that many sellers do to ensure that their employees have a future with the buyer, it may be a feature that’s customary with these kinds of loans because of the regulatory requirements regarding employees. We’re as likely to see that in these transactions as ever because I’m sure a key part of the government’s policy offering these kinds of loans is to preserve people’s jobs, and that’s what those provisions do.

Simon: Absolutely right. Any parting words for PPP or Main Street loan borrowers who are potential M&A targets prior to maturity of their loans?

Swartz: I would say that there are so many things to think about when you’re selling your company, and it’s easy to lose track of some of the details. With respect to these loans, this is not the usual situation. This is not merely a loan; it’s a regulated loan. And you need to take careful account of how the loan proceeds are going to be used and how the cash from the loan is going to be treated. I think the practice of good contracts, planning carefully and precisely around this is key. Because if sellers don’t do that, they could find themselves liable for problems that were actually created after they sold their company. So take care, and draft good agreements.

Simon: Thank you, Matt, for a great and timely discussion.