Takeaways

New Small Business Administration (SBA) guidance implementing the Paycheck Protection Program (PPP) confirms that a somewhat narrower set of affiliation principles now applies to SBA loan programs, including the PPP.
This guidance, importantly, also indicates that SBA affiliation rules regarding “negative controls” nonetheless apply—continuing to raise issues of control by minority investors, including VCs and PEs, by virtue of certain standard protective provisions.
SBA’s regulations and guidance also contain important updates concerning other aspects of applicant eligibility.

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), passed on March 27, 2020, sets aside $349 billion for Paycheck Protection Loans, which are available through banks, credit unions and other lenders (and guaranteed by the government) and allows for forgiveness of certain amounts. We summarized the Act’s small business loan provisions here; and what funds, corporate investors and their portfolio companies should know about eligibility for the paycheck protection program here.

Most major lending banks began to accept applications by or before Monday April 6, 2020 and, as applicants rushed to prepare them, the SBA and Treasury Department issued a flurry of interim rules and guidance interpreting the CARES Act provisions. The full legal import of much of this guidance is not yet clear.

We summarize below key aspects of these documents that may be of most interest to many of our clients

Applicable Affiliation Principles

The April 3 SBA publication clarified that the CARES Act limited the rules of affiliation for the PPP (and other SBA loan programs) to just four principles. These principles, in summary, are:

  • Affiliation based on ownership or the power to control more than 50 percent of the concern’s voting equity. SBA includes, as part of this affiliation principle, “negative control” by a minority owner.
  • Affiliation arising under stock options, convertible securities, and agreements to merge.
  • Affiliation based on common management, such as common officers or and directors who control the control concerns.
  • Affiliation based on identity of interest between close relatives with substantially identical business interests.

Remarkably, the CARES Act rescinded other affiliation principles that SBA had just put into effect earlier in the month for its loan programs. These other principles—which are not applicable to the PPP—are as follows: 

  • Affiliation based on an identity of interest arising from common investments or economic dependence.
  • Affiliation based on the “totality of circumstances,” a catch-all, under which affiliation may be found.
  • Affiliation based on the “newly organized concern” rule, which finds affiliation in the creation of certain new entities by persons associated with a prior concern.

Negative Control

Although the CARES Act narrowed the affiliation rules in these respects, SBA’s April 4 memorandum states that SBA’s traditional view of “negative control” nonetheless applies to the PPP. The first principle of affiliation is affiliation based on ownership. 13 CFR § 121.301(f)(l). This regulation goes on to state that SBA will deem a minority shareholder to be in control if it has the ability, under the concern's charter, by-laws, or shareholder's agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders. Id. SBA’s April 4 memorandum, citing this regulation, affirms SBA case law that holds a minority investor is deemed to control a company if it possesses veto power over certain corporate actions that SBA has considered to be essential to the daily operations of the business. We discussed such negative controls here.

The good news is that SBA and Treasury’s April 6 FAQs have provided clear advice on one way avoid a finding of negative control: 

Question: The affiliation rule based on ownership (13 C.F.R. 121.301(f)(1)) states that SBA will deem a minority shareholder in a business to control the business if the shareholder has the right to prevent a quorum or otherwise block action by the board of directors or shareholders. If a minority shareholder irrevocably gives up those rights, is it still considered to be an affiliate of the business?

Answer: No. If a minority shareholder in a business irrevocably waives or relinquishes any existing rights specified in 13 C.F.R. 121.301(f)(1), the minority shareholder would no longer be an affiliate of the business (assuming no other relationship that triggers the affiliation rules).

In other words, where an investor presently holds negative controls that otherwise would give rise to a finding that the investor and, for example, its portfolio company, are affiliates of the applicant, those negative controls may be relinquished in order to sever affiliation—but SBA advises that such a waiver of rights must be irrevocable.

An Applicant Can Qualify Under Alternative Size Standards

Although the CARES Act appeared to change the definition of “small business concern” to one that employs not more than 500 employees—or a higher employee-based standard applicable to the applicant’s primary industry—SBA’s latest guidance clarifies that businesses can qualify for PPP loans if they meet either the revenue-based size standard for their primary industry or SBA’s “alternative size standard” for its loan programs, specifically:

As of March 27, 2020: (1) maximum tangible net worth of the business is not more than $15 million; and (2) the average net income after Federal income taxes (excluding any carry-over losses) of the business for the two full fiscal years before the date of the application is not more than $5 million.

Again, these are all alternative tests.

Calculation of Number of Employees for Size Eligibility Purposes

After pointing out the idiosyncrasies of the language of the CARES Act, SBA’s April 4 memorandum affirms that an applicant should calculate its number of employees based on an average from the 12 completed months preceding the date of the application.  That approach is consistent with SBA’s longstanding regulations.  SBA’s April 6 FAQs, however, state that an applicant may, alternatively, use its average employment over the time period used to calculate its maximum loan amount, including the seasonal and newly-formed businesses designated periods.  Thus, applicants may select different measurement periods in assessing their size eligibility, depending on their circumstances. 

Independent Contractors Not Included for Loan Amount or Employee Count

Another key issue resolved in one of SBA’s Interim Final Rules is the treatment of independent contractors. While the CARES Act could be read to permit an applicant to include independent contractors in its calculation of loan amount, the rule states clearly that independent contractors should not be included in either the calculation of loan amount or the business’s number of employees.

Treatment of $100,000 Salary Cap

The April 6 FAQs also clarify the CARES Act’s directive to exclude payroll costs for any employee in excess of a $100,000 salary. The Act instructs applicants, for the purposes of calculating loan amounts and loan forgiveness, to effectively cap all employee salaries at $100,000. Thus, if any employee’s salary is greater than $100,000, that employee’s salary should be treated as $100,000 for the purposes of CARES Act loan calculations. The April 6 FAQs clarify that this $100,000 cap does not apply to employee benefits including: (1) employer contributions to defined-benefit or defined-contribution retirement plans; (2) payment for the provision of employee benefits consisting of group health care coverage, including insurance premiums; and (3) payment of state and local taxes assessed on compensation of employees. Those costs, in addition to salary up to $100,000, may be included in the computation of payroll.

Additional Resources

These are just highlights of SBA’s recent implementing regulations and guidance. Pillsbury attorneys can help clients interpret and assess the PPP requirements as clients assess and strategize regarding the availability of SBA loan. We are proactively monitoring any forthcoming regulations and guidance.


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