On April 23, 2020, the Small Business Administration (SBA) and Department of Treasury issued a new FAQ regarding the “necessity” certification that borrowers are required to make when applying for a loan under the Paycheck Protection Program (PPP). This FAQ highlights the requirement that this certification be made in good faith and that borrowers may be scrutinized and subject to liability for making this certification when the underlying facts of their business do not support the certification. The SBA announced that any borrower that applied to a PPP loan prior to the issuance of this FAQ and repays the loan in full by May 7, 2020, will be deemed to have made the required certification in good faith.
On April 24, 2020, the SBA issued its fourth Interim Final Rule that clarifies various lender issues, broadens the PPP to include businesses that are engaged in legal gaming activities, hospitals that receive less than 50% of their funding from state or local governments (exclusive of Medicaid) and businesses participating in an ESOP. It also clarifies that hedge funds and private equity funds are ineligible to receive PPP proceeds, reiterates the requirement that the affiliation rules must be applied to portfolio companies and emphasizes that such companies must make the “necessity” certification.
The FAQ focused on businesses owned by large companies that have adequate sources of liquidity to support the business’ ongoing operations. The FAQ highlights that the CARES Act suspends the ordinary requirement that borrowers must be unable to obtain credit elsewhere, but notes that borrowers still must certify in good faith that their PPP loan request is necessary. The FAQ notes that borrowers must make the following certification in good faith: “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” In doing so, borrowers should take 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. The FAQ also states that 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. In such a case, a company should be prepared to demonstrate the basis for its certification to the SBA.
The 4th Interim Final Rule codified the safe harbor from the FAQ that permits borrowers who are uncertain about their ability to make the “necessity” certification an opportunity to repay their PPP loan and mitigate the risk of liability. Specifically, the 4th Interim Final Rule provides that, “Any borrower that applied for a PPP loan prior to the issuance of this regulation and repays the loan in full by May 7, 2020 will be deemed by SBA to have made the required certification in good faith.” This safe harbor only applies to the “current economic uncertainty” certification.
Taken together, the FAQ and the 4th Interim Final Rule could be read as an indication that, despite the guidance that was in effect at the time of a borrower’s application, borrowers that are audited will be held to a higher standard than was in effect prior to the FAQ. In particular, the FAQ’s reference to the borrower requiring the loan based on its “current business activity” could be read as being more restrictive than the CARES Act standard of “current economic uncertainty”. The use of the term “uncertainty” implies projected economic harm even if the business has not yet been impacted, while “current business activities” seem to require that a borrower will need to demonstrate that the adverse economic impact had already occurred. In addition, despite the specific waiver of the “credit elsewhere” requirement for PPP loans under the CARES Act, the FAQ requires borrowers to take into account their ability to access other sources of liquidity. Notably, the FAQ is included in a broader set of FAQs that are qualified by a footnote saying that, “This document does not carry the force and effect of law independent of the statute and regulations on which it is based.” In addition, although the safe harbor referenced in the FAQ was codified into the 4th Interim Final Rule, the other details of this FAQ were not.
The FAQ was driven by adverse publicity regarding Shake Shack, Ruth’s Chris Steakhouse, and other large companies that operate businesses that were able to obtain a PPP loan because their NAICS code begins with 72. Despite the specific reference to large public companies that have access to the capital markets, it is likely that an auditor will also consider whether the borrower had other sources of liquidity such as access to a large undrawn revolver or a significant amount of cash on hand. Most concerning for private equity and venture capital funds is whether the SBA and Treasury will view equity infusions by the funds as a source of liquidity. Private equity and venture capital firms lobbied intensively for the SBA to loosen the affiliation rules. Nancy Pelosi and Kevin McCarthy also pushed to include private equity and venture capital backed portfolio companies, and none of these efforts led to a loosening of the affiliation rules. This could mean that the SBA intends to scrutinize portfolio companies to determine whether the PPP loan was in fact necessary. One would hope that the SBA will focus on the fact that private equity and venture capital funds cannot just throw money at portfolio companies. Most are backed by state pension funds, corporate ERISA funds, and other investors who expect a return on their investment. A fund does not generally have a pool of money that can tapped at any time, but rather must call capital from investors, usually with at least ten business days’ notice. The ability of a fund manager to call and invest capital are proscribed by carefully negotiated documents. A private equity or venture capital fund can be a source of liquidity under the right circumstances, but private equity and venture capital funds would not normally invest equity into a troubled company except in a negotiated deal with the portfolio company’s existing lenders, which is not a fast and simple process (and it costs a lot of money). Moreover, funding for a distressed company from a private equity or venture capital investor may come on terms that are “significantly detrimental to the business” of the portfolio company, or at a minimum much more detrimental than the terms of a PPP loan.
We recommend that all PPP borrowers carefully assess their circumstances before submitting a PPP loan application and create a record that articulates the need for the PPP loan and provides facts that support its certification. We further recommend that each applicant submit the application based on a reasonable and good faith belief/expectation that the adverse impact on its business from the shutdown has already occurred and that the impact will continue (i.e., layoffs/furloughs) over the next several months, and that the PPP funding would enable the company either to avoid those cutbacks or reduce their scope. Applicants should document any decrease in its business due to COVID-19, supply chain issues, loss of revenue, inability to operate at full capacity and any other facts that support the economic necessity. Ultimately, the intent of the PPP program is to prop up employment, so if a company can say reasonably, after considering all of its relevant circumstances, that, in the absence of the program, it would take steps to reduce headcount/expense in the near term and conversely that with the program those steps would be avoided or mitigated, then the company may have a reasonable basis for certifying its need for the loan request.
In addition to the assessment described above, private equity and venture capital portfolio companies and their owners should document the difficulties associated with a potential equity infusion. This could be a summary of where the fund is in its life cycle, the applicable provisions of the fund documents relating to investments, financial information and other relevant facts. Despite the fact that portfolio companies are backed by private equity sponsors or venture capital investor, PPP loans are as necessary for portfolio companies as for any other small business. The mere fact that a company has a private equity or venture capital investor does not mean that it did not have a need for the PPP loan. As long as there is truly a need that is documented and the loan proceeds are used for permitted purposes, the portfolio company should be able to withstand an audit. However, the defense may be costly both in terms of legal costs and the hit to the private equity or venture capital fund’s reputation.
This would be a good time for private equity and venture capital funds to re-evaluate their portfolio companies’ applications and determine whether to withdraw an application or repay an existing PPP loan. In evaluating whether to pay a loan back prior to May 7, 2020, private equity and venture capital funds should expect that all information relating to the PPP application are related materials will be made public. This is especially true in light of the Federal Reserve’s announcement on April 23, 2020 that they intend to make public details regarding loans made pursuant to the CARES Act. Also, private equity and venture capital funds should understand that in addition to (and more serious than) the public relations issues, there are legal consequences to making a false certification on a PPP application. Knowingly false certifications violate federal criminal law and can result in jail time and significant financial penalties, and certifications made with reckless disregard for, or intentional ignorance of, the truth can result in civil False Claims Act liability for, as an example, three times the value of the loan plus additional financial penalties. You can read more about these risks in the context of PPP loan applications here.