As we have discussed in previous alerts, one of the key features of the recently passed Coronavirus Aid, Recovery, and Economic Security (CARES) Act is the Paycheck Protection Program (PPP). Under this program, Congress allocated $349 billion in low-cost loans for small businesses to access to help pay for payroll, rent, utilities, and other operating costs. Up to eight weeks of allowable costs are forgivable under the PPP, meaning that the loans can effectively turn into grants. Venable has provided considerable coverage of the PPP, and the larger CARES Act, which can be accessed here.
The PPP is being administered by the U.S. Small Business Administration (SBA), which brings with it a complex set of rules and qualifications that businesses must navigate. One of the continuing points of confusion is around the concept of affiliation. The SBA has issued varied guidance and rules over the past week, most recently on April 3, 2020. This alert will briefly explain the most recent affiliation rules and outline some considerations for potential applicants to address and consider.
SBA size standards and affiliation, generally
The PPP is administered as part of the SBA's 7(a) loan program. The SBA has a series of regulations that govern what businesses are eligible for these loans. One of the most important rules addresses the size of eligible businesses, referred to as the size standards. Under the size standards, in general, a business must not exceed a maximum employee head count or revenue total assigned to its particular industry (see, e.g., 13 C.F.R. § 121.201), or meet alternative criteria based on net worth and average net income.
The affiliation rules govern which business entities are counted for the purposes of determining size. If businesses are affiliated, their employees or revenues are combined and counted together. Generally speaking, if one business has the power to control another, there is affiliation. The power to control can come about in several different ways—the SBA rules contain several different tests for affiliation.
What are the relevant affiliation rules?
The SBA regulation contains two affiliation rules: 13 C.F.R. section 121.103 and section 121.301. The recent SBA guidance and interim final rule on affiliation make it clear that section 121.301 is the correct rule to apply. This was again reaffirmed on April 6, 2020, when the SBA issued a new set of frequently asked questions (FAQs). This was expected because section 121.301 specifically addresses size and affiliation with regard to the 7(a) loan program (and SBA financial assistance programs in general).
Another wrinkle is that the CARES Act permanently rescinds the February 10, 2020 interim final rule that updated section 121.301(f) effective March 11. See CARES Act, § 1102(e). Thus, when reviewing that regulation, one must use the prior version, which contains fewer affiliation rules than the recently rescinded one (note that, as of this alert, a simple internet search usually turns up the now-rescinded version of the rule). The most commonly applied affiliation rules remain unchanged, but this is a nuance that should be noted.
How do I know if there is affiliation?
The baseline rule for affiliation is that "Concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists." § 121.301(f). To determine if there is control, the SBA's recent guidance makes clear that the SBA is focusing on the four tests contained in section 121.301(f): (1) affiliation based on ownership; (2) affiliation arising under stock options, convertible securities, and agreements to merge; (3) affiliation based on management; and (4) affiliation based on identity of interest. In fact, the most recent guidance largely mirrors the regulation, directly quoting most of section 121.301(f). The FAQs have also added helpful commentary on certain aspects:
- Affiliation based on ownership (§ 121.301(f)(1)). Businesses are affiliated if one entity or person "owns or has the power to control more than 50 percent of the concern's voting equity." In addition, a minority shareholder can be in control if they can exercise what the SBA refers to as "negative control"—powers such as the ability to deny a quorum or block certain board or shareholder actions. However, per the FAQs, if a minority shareholder irrevocably gives up those rights, they would no longer be affiliated under this test. This is particularly notable, as it affirms our understanding that dis-affiliating from an investor or controlling party is possible prior to applying for PPP funds.
- Affiliation arising under stock options, convertible securities, and agreements to merge (§ 121.301(f)(2)). If stock options, convertible securities, or an agreement to merge has a "present effect on the power to control a concern," then there is affiliation. The emphasis here is on "present effect," so if there is a condition precedent to the exercise of, say, an option, then there is no present effect.
- Affiliation based on management (§ 121.301(f)(3)). If an officer, managing member, partner, or other principal of an entity also "controls the management of one or more other concerns," then there is affiliation. There is also affiliation through common management if a particular person or entity controls the board or management of another concern.
- Affiliation based on identity of interest (§ 121.301(f)(4)). There is affiliation if "there is an identity of interest between close relatives" and they have "identical or substantially, identical business or economic interests."
The most common forms of affiliation are ownership and common management, particularly for private equity or venture capital-backed businesses. Because of the structure of these entities, affiliation can become a complex analysis that requires looking at equity shares, voting rights, board positions, stock options, and other rights relevant to control.
Determining whether there is affiliation is often a fact-dependent analysis. The ownership rule that states there is affiliation if an equity stake grants a greater than 50 percent voting stake is the only clear rule here. In addition, the FAQs place the burden of determining what entities are or are not affiliated for purposes of qualifying for the PPP on the borrower, not on the lender. The lender is permitted to rely upon the borrower's representations regarding affiliation.
Affiliation waivers under the CARES Act
In order to determine if a firm can receive a PPP loan, it must satisfy the CARES Act's eligibility requirements in Section 1102. This means that a business, for the purposes of determining size, must consider affiliation when considering its employee head count. Note, the FAQs also affirm our statutory interpretation that any "small business concern," as defined by the Small Business Act, also qualifies for the PPP. Thus, if a concern qualifies under their NAICSs codes' revenue standard or under the alternative size standard, irrespective of head count, they too qualify. However, the CARES Act waives the affiliation rules in only three discrete situations:
(I) Any business concern with not more than 500 employees that, as of the date on which the covered loan is disbursed, is assigned a North American Industry Classification System [NAICS] code beginning with 72;
(II) Any business concern operating as a franchise that is assigned a franchise identifier code by the Administration; and
(III) Any business concern that receives financial assistance from a company licensed under section 301 of the Small Business Investment Act of 1958 (15 U.S.C. 681).
CARES Act, § 1102(a)(36)(D)(iv). Unless one of these waivers applies to the business in question, the affiliation rules still apply. If the affiliation rule is waived, it allows the business in question to consider its eligibility for a PPP loan without considering the implications of affiliation. The waivers do not, however, mean that the business is automatically eligible.
The SBA also stated in the FAQs that the affiliation exceptions at 13 C.F.R. § 121.103(b) are also applicable. These are highly specific, having to do with ownership by Indian Tribes, Alaska Native Corporations, Native Hawaiian Organizations, and Community Development Corporations, and apply only to a small subset of potential PPP applicants.
Conclusion
SBA's recent guidance on affiliation points applicants toward the affiliation standards contained in section 121.301(f). That regulation provides four means by which firms can be affiliated, which can often be a complicated analysis. The waivers to affiliation under the CARES Act are also limited, which unfortunately means that many small businesses backed by private equity or venture capital firms may find themselves without assistance under this statute. These concerns have made their way to the Administration and Congress, but as of the date of original publication, no relief from these affiliation standards has been granted. Venable attorneys are keeping up with the ever-changing guidance coming from the SBA and can help clients navigate this complex regulatory landscape.