Satisfying the “Need” Requirement for a Paycheck Protection Program Loan
On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which, among other things, established the Paycheck Protection Program (PPP) within the U.S. Small Business Administration’s (SBA) 7(a) Loan Program. Phase 1 of the PPP provided the SBA with $349 billion in funds to be used to guarantee 100% of the amounts loaned under the PPP by lenders to eligible small businesses, nonprofits, veterans organizations, and tribal businesses. The full principal amount and accrued interest of loans under the PPP may qualify for loan forgiveness. For more information on the PPP, please refer to the previous client alerts from our firm and Pepper Hamilton LLP (available here and here).
The application process for Phase 1 of the PPP opened on April 3, 2020, and funding was depleted on April 16, 2020, at which time the SBA announced that it had stopped accepting applications for the initial round of PPP loans. Several large companies, including public companies, participated in Phase 1 of the PPP, while many small companies were unable to access PPP funds.
Within the last week, legislators, regulators, the media and the public have questioned the need for public companies and other larger companies to participate in the PPP. In particular, stakeholders have focused on the certification in the PPP application that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the [a]pplicant.”
On April 20, 2020, U.S. Senator Marco Rubio, Chairman of the Senate Committee on Small Business and Entrepreneurship, indicated that his committee would conduct aggressive oversight of the PPP, including whether borrowers made false certifications in order to receive loans. He indicated that he would use the committee’s subpoena power to compel cooperation. In addition, on April 24, 2020, Senators Chuck Schumer, Elizabeth Warren and other Democrats called on government watchdogs to investigate the PPP amid concerns that large companies received too much of the available funds.
On April 22, 2020, Treasury Secretary Steven Mnuchin indicated that he thought it was questionable whether public companies qualified for the PPP. Secretary Mnuchin indicated that if public companies do not return PPP funds, they “could be subject to investigation.”
In the wake of this media, political and public scrutiny, a number of public and other larger companies, including Shake Shack, Ruth’s Chris Steak House, Kura Sushi, J. Alexander’s and Sweetgreen, agreed to return PPP funds they received in Phase 1.
In response to the scrutiny of Phase 1 loan recipients, on April 23, 2020, the SBA added Question 31 to its PPP Frequently Asked Questions (FAQ #31). FAQ #31 provides that “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.” This guidance further states that when making this certification, borrowers should consider “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.” FAQ #31 then 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, and such a company should be prepared to demonstrate to SBA, upon request, the basis for the certification.” Finally, this guidance states that “[a]ny borrower that applied for a PPP loan prior to April 23, 2020 and repays the loan in full by May 7, 2020 will be deemed by SBA to have made the required certification in good faith.”
In light of FAQ #31, several lenders have updated their PPP applications to require borrowers to acknowledge that they: (i) have read the SBA’s PPP Frequently Asked Questions, including FAQ #31; and (ii) remain eligible for a loan under the PPP.
On April 24, 2020, President Trump signed the Paycheck Protection Program and Health Care Enhancement Act, which provided $310 billion in additional funding for the PPP. For more information, please refer to our client alert summarizing the key points of this legislation, available online here. The SBA began accepting Phase 2 PPP loan applications on Monday, April 27, 2020.
Potential Liability of Public and Large Companies
The act of providing false information or a false certification to obtain a loan under the PPP or other federal loan assistance program is subject to civil and criminal prosecution. It is uncertain how these potential prosecution threats would be applied in the context of the “need” certification in the PPP application as is currently being discussed in political and public forums.
It should be noted that in order to facilitate the availability of funds under the PPP and to encourage banks to quickly extend loans in reliance on the program, the program explicitly waived the customary SBA requirement that applicants first seek alternate sources of credit as a prerequisite to applying for a loan. Furthermore, the primary legislative purpose of the PPP was to provide funds in the form of forgivable loans (i.e., grants) to companies so that they would forego or limit otherwise likely and inevitable employee terminations and furloughs during the COVID-19 pandemic, particularly to workers in food service businesses (many of which are franchisees) that are now being publicly scrutinized after the fact. Furthermore, a plain reading of the “need” certification in the PPP loan application, namely that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the [a]pplicant,” does not imply that publicly traded companies or large private companies are necessarily ineligible or otherwise would not qualify.
Companies of all sizes have suffered from dislocations caused by COVID-19 and governmental responses, including the closure of businesses deemed to be non-essential. Almost all companies are facing unpredictable futures due to the current “economic uncertainty,” as a result of which many public companies have withdrawn their previously-issued earnings guidance. No legislative or regulatory guidance was provided to Phase 1 PPP applicants as to how to evaluate whether a loan was “necessary to support the ongoing operations of the [a]pplicant.”
FAQ #31, which was issued after Phase 1 was completed, provides 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,” but the FAQ does not define what level of market value would be considered “substantial.” Furthermore, FAQ #31 provides little guidance on what constitutes “access to capital markets.” Many public companies have seen their access to credit markets evaporate and their equity valuations plummet as a result of COVID-19 and governmental responses and are unable to access the capital markets at this time. We believe that many public companies can reasonably conclude that a PPP loan is “necessary to support [their] ongoing operations.”
As a result of the lack of meaningful definitions or other precise qualification requirements, at least as to loans borrowed during Phase 1, the current scrutiny of public and larger PPP borrowers seems to be motivated by political purposes. Nevertheless, this type of scrutiny can frequently be a powerful driver to influence companies’ behavior. In this case, it could undermine the purpose of the PPP.
Directors of public and other large companies that borrowed funds under Phase 1 of the PPP and have come under scrutiny or that are considering borrowing in Phase 2 will need to carefully consider the potential ramifications of retaining the funds or applying for new funding. The threat of a federal investigation should be taken seriously, given the expense, management distraction, and reputational harm that could result, even if the company’s PPP application complied with all applicable requirements.
Approach to PPP Participation by Public and Large Companies
Given the updated SBA guidance and increased scrutiny of PPP loan recipients, we believe that public and large companies should implement certain “best practices” in determining whether to apply for a loan under Phase 2 of the PPP, or in determining whether to repay a PPP loan funded in Phase 1:
1. Determine Need
First, borrowers and prospective borrowers should consider FAQ #31 and analyze their ability to provide the need certification. In order to do so, borrowers and prospective borrowers should gather their accounting, finance, legal and operational teams and analyze the business activity and sources of liquidity at the time of the application.
Current Business Activity. The working group should discuss in detail the impact of the COVID-19 pandemic on the company’s operations, including customer demand, supply constraints, required or recommended restrictions on operations and employee dislocation.
Sources of Liquidity. Next, the working group should examine the company’s sources of liquidity. The finance and legal teams should describe the company’s ability to obtain equity financing. For a private company, the working group should examine the company’s LLC Operating Agreement to determine whether members are required to contribute additional capital. For a public company, the working group should consider whether the company has effectively accessed equity markets in the last two to three years and whether there is a realistic ability to access the equity markets on commercially reasonable terms given the current state of the markets.
Also, the working group should examine the company’s access to debt financing on commercially reasonable terms given the current state of the markets. The finance team should report to the working group on the company’s ability to access lines of credit or other debt financing, including whether the COVID-19 pandemic has caused the company to breach any of its loan covenants.
After examining the availability of sources of liquidity, the working group should consider the potential terms of such financing sources. FAQ #31 indicates that borrowers should focus their review on “sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.” We believe this means that applicants need only consider reasonable sources of liquidity. Therefore, if available liquidity would require the company to issue significant amounts of equity at unfavorable valuations, accept lending arrangements with high interest rates or other unfavorable and potentially severely restrictive terms, or sell off a portion of the company’s assets to raise sufficient liquidity, the applicant should still be able to satisfy the need requirement for participating in the PPP.
If a public or large company believes that it can demonstrate the requisite need, it should memorialize all relevant facts so that it has a record of its current situation that can be used to defend itself against future scrutiny. If a public or large company does not believe that it can demonstrate the requisite “need,” or concludes that the benefit of receiving a PPP loan would be outweighed by the potential reputational harm that may result from adverse political, media and public reaction, it should consider returning Phase 1 funds or not applying for Phase 2 funds.
2. Consider the Political, Media and Public Reaction
Once a public or large company has determined that it can properly provide the “need” certification and otherwise qualifies for a PPP loan, it should weigh the benefit of PPP funds against the political, media and public reaction to participating in the program. In particular, public and large companies should consider whether they have or plan to furlough employees, terminate employees or reduce employee compensation. The primary legislative purpose of the PPP was to provide funds to small businesses so that they would forego or limit employee terminations and furloughs during the COVID-19 pandemic. If a borrower plans to use the funds for authorized purposes under the PPP (e.g., payments of interest on mortgage obligations, rent, utilities and interest on any other debt obligations that were incurred before February 15, 2020), but terminates or furloughs large portions of its employee base, it will be subject to increased scrutiny even though there is no requirement in the PPP to use the proceeds primarily for payroll expenses, unless the company expects to seek forgiveness of the loan.
Public and large companies also should consider other factors that would increase scrutiny of their participation in the program. For instance, even though participation in the PPP does not impose explicit limitations on executive compensation or stock buybacks (unlike other loan assistance programs under the CARES Act such as the Main Street Lending Program), large executive compensation and stock buybacks would be fertile ground for criticism of PPP participants. Therefore, borrowers should consider their history and future plans for executive compensation payments and stock buybacks before retaining Phase 1 funds or borrowing funds under Phase 2.
In addition, a public company borrower should consider its financial results for the first quarter of 2020 and expected financial results for the remainder of the year. If a public company expects to release strong results for the first quarter 2020, it should explain in its earnings release and Form 10-Q that the impact of COVID-19 was not fully realized in the first quarter, but that it expects to feel an impact in the second quarter and in future quarters.
3. Communicate with Your Board
Depending on the size of the loan and other factors, some borrowers may need approval of their Board of Directors or other governing body. In connection with such approval, we believe the determination of need should be presented to, and considered by, the Board or governing body. Even if a business is not required to seek the approval of its Board or governing body, the officers or managers of the business should communicate their intention to participate in the program and should strongly consider securing board approval in any event given the possibility of regulatory and media scrutiny.
4. Develop an Effective Communication Strategy
The PPP application states that information about PPP loans, including borrower name and loan amount, is subject to public disclosure under the Freedom of Information Act. In furtherance thereof, on April 23, 2020, the Federal Reserve announced that it will report substantial amounts of information on a monthly basis for the liquidity and lending facilities using CARES Act funding, including the:
- Names and details of participants in each facility;
- Amounts borrowed and interest rate charged; and
- Overall costs, revenues, and fees for each facility.
Therefore, borrowers should develop a communication strategy to prepare for the eventual public disclosure of their participation in the PPP. In particular, borrowers should be able to: (i) describe how COVID-19 has impacted, and is reasonably expected to impact, their business; (ii) communicate the need for the PPP loan; and (iii) indicate the uses of the PPP proceeds, particularly as they relate to employee retention and remuneration.
Summary
Make no mistake: The authors do not want to discourage any eligible business from participating in the PPP. However, eligibility in the program and the potential related scrutiny and institutional reputational harm should be carefully considered. Public and large companies should carefully document their need for participation in the program. In addition, public and large companies should communicate with their Boards or governing bodies, consider public reaction to their participation and develop a strategy to communicate effectively with their stakeholders.
(i) According to an article published by CNBC on April 26, 2020, more than 200 public companies applied for at least $845.7 million of PPP loans. See linked article: https://www.cnbc.com/2020/04/26/small-business-loans-public-companies-took-855-million.html.
(ii) A false statement or claim in violation of 18 USC 1001 can lead to imprisonment of not more than five years and/or a fine of up to $250,000; a false statement in connection with an application for a loan in violation of 15 USC 645 can lead to imprisonment of not more than two years and/or a fine of not more than $5,000; and under 18 USC 1014, a false statement or certification to a federally insured institution, can lead to imprisonment of not more than 30 years and/or a fine of not more than $1,000,000.