What a difference a week can make! COVID-19 is requiring constant adaptation and flexibility on a scale not seen in our lifetimes on all sorts of fronts, and the rules regarding the SBA’s Paycheck Protection Program (PPP) are no exception. The SBA and U.S. Treasury have now “clarified” their affiliation rules such that our March 29 Legal Update is incorrect – or at least of only historical significance.
Background. The CARES Act expanded the Small Business Administration’s (SBA) Section 7(a) Paycheck Protection Program or PPP loans to all “small businesses” and made PPP loans significantly more attractive by making them forgivable. The new PPP loans have been the subject of several prior Client Alerts and SBA guidance, all available on our COVID 19 Resource Center. Most businesses are eligible so long as they have 500 or fewer part or full-time employees, and businesses in industries with certain NAICS codes can qualify with more employees. This Client Alert focuses on whether entities are affiliated and need to be combined for purposes of determining the number of employees.
Since our last article just two weeks ago, the SBA issued new guidance that changed the application of the affiliation rules. We summarize the new guidance below.
Recent Developments Alter the Affiliation Tests
The Treasury and the SBA both released guidance on April 3, detailing how the affiliation rules apply for purposes of determining an entity’s eligibility to receive a PPP loan. The SBA’s website contains guidance, entitled the “Affiliation Rules Applicable to U.S. Small Business Administration paycheck Protection Program”, and the SBA published a Supplemental Interim Final Rule (collectively, the “Updated Affiliation Guidance”).1
As a threshold matter, the Updated Affiliation Guidance relies on different statutory references for affiliation than the CARES Act. The CARES Act suggested that affiliation should be tested under the (generally expansive) rules in 13 CFR 121.103. (CARES Act § 1102(a)(2)(D)(iv), (vi).) Pursuant to the Updated Affiliation Guidance, however, PPP borrowers can test affiliation using the more narrow affiliation rules of 13 CFR 121.301.2 Keep in mind that the CARES Act itself repealed February 2020 guidance on affiliation in connection with other SBA programs.3
Further, although the Updated Affiliation Guidance references the rules promulgated in 13 CFR 121.301(f), the Treasury Department appears to expressly limit the scope of those rules by focusing on only four of the eight tests for affiliation in the cited regulation:
“Four tests for affiliation based on control apply to participants in the Paycheck Protection Program. For purposes of the determining the number of employees of an applicant to the Paycheck Protection Program, the applicant is considered together with its affiliates. Following is a summary of the applicable affiliation tests.” (Emphasis in the original.)
The SBA thus appears to be allowing PPP borrowers to disregard the other affiliation tests, most notably the test based on the totality of the circumstances. This provides welcome relief to businesses concerned with that broader and more ambiguous affiliation test.
The New and Improved Tests
Below are the four affiliation tests retained by the Updated Affiliation Guidance:
- Affiliation based on 50 percent or more equity ownership, or an ability to control using negative covenants. (13 CFR 121.301(f)(1).) A PPP loan applicant is an affiliate of an individual, concern or entity that owns or has the power to control more than 50 percent of the business’s voting equity. Here, the SBA also “deem[s] a minority shareholder to be in control, if that individual or entity 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.”
Significantly the SBA’s FAQs provide that borrowers may rearrange their affairs to avoid affiliation, though it is unclear whether such right may be limited to only this particular affiliation test:
6. 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).
- Affiliation based on the power to control based on options, convertible securities, and agreements to merge. (13 CFR 121.301(f)(2).)
- Affiliation based on management. (13 CFR 121.301(f)(3).) Under this test, affiliation arises where the CEO or President (or other officers, managing members, or partners who control the management of the concern) controls the management of the applicant concern and another concern.
- Affiliation based on identity of interest. (based on 13 CFR 121.301(f)(4).) The Treasury Department shortens and simplifies this traditional SBA affiliation rule to:
(4) Affiliation based on identity of interest. Affiliation arises when there is an identity of interest between close relatives, as defined in 13 CFR 120.10, with identical or substantially, identical business or economic interests (such as where the close relatives operate concerns in the same or similar industry in the same geographic area).
Under this test, affiliation exists between close relatives (defined in 13 CFR 121.10 to include only spouses, parents, children, siblings or the spouse of any such person) with identical or substantially identical business or economic interests. In focusing on relationships between close relatives, the Treasury Department seems to have eliminated affiliation based on common investments and economic interdependence that are included in clause (f)(4) of the cited regulations.
FAQ 4 of the SBA FAQs for PPP loans indicates that it is the responsibility of the borrower to determine which entities (if any) are its affiliates and determine the employee headcount of the borrower and its affiliates. Lenders are permitted to rely on borrowers’ certifications:
Question: Are lenders required to make an independent determination regarding applicability of affiliation rules under 13 C.F.R. 121.301(f) to borrowers?
Answer: No. It is the responsibility of the borrower to determine which entities (if any) are its affiliates and determine the employee headcount of the borrower and its affiliates. Lenders are permitted to rely on borrowers’ certifications.
In applying 13 CFR 121.301(f)(4), however, it appears that the lender (in this context, the SBA) makes a determination that the borrower can refute: “Where SBA determines that interests should be aggregated, an individual or firm may rebut that determination with evidence showing that the interests deemed to be one are in fact separate.” It is unclear how to apply this provision when the borrower makes the initial affiliation determination.
Example. When their parents died, two sisters each inherited a half interest in each of two separate businesses. Sister Alice runs one business, a used car dealership and auto parts store with 400 part-time employees. Across town, Sister Beatrice runs a new motorcycle dealership and repair shop with 300 full and part-time employees. Each sister manages their respective business and the other sister is simply a passive investor sharing equally in net profits. If the two businesses are affiliated, neither is eligible for a PPP loan.
Clearly, there is a substantially identical economic interest between Sister Alice and Sister Beatrice. But should that be reason enough to cause the distinct businesses to be combined and denied a PPP loan? Would it make a difference if Beatrice’s repair shop regularly bought some merchandise from Alice’s auto part’s store? Would it make a difference if the sisters lived together or across the country? Whether they were close or estranged? Should each just apply for their own PPP loan, identify the potential affiliation on their application, and wait until the SBA challenges it?
Churches
Finally, it is also worth noting that the government is bending over backwards to accommodate churches who might otherwise be considered affiliated with their dioceses. The Treasury’s Guidance thus provides:
Religious Exemption. The relationship of a faith-based organization to another organization is not considered an affiliation with the other organization if the relationship is based on a religious teaching or belief or otherwise constitutes a part of the exercise of religion.
The SBA’s Supplemental Interim Final rule provides several pages of explanation as to why exemption of faith-based organizations from the SBA’s affiliation rules is necessary to avoid imposing a (constitutionally and legislatively impermissible) substantial burden on the free exercise of religion. We will leave it to others to debate whether the government is promoting or undermining the First Amendment’s Free Exercise clause by facilitating the use of PPP loans to help the faith community pay salaries for religious leaders, along with their rent, untilities and mortgage interest.
Conclusion
The affiliation rules have morphed several times since the Treasury Department issued its Affiliation Standards for Express Loans in February. Those changes generally benefit many businesses and churches that might otherwise have been deemed affiliated under prior SBA guidance. Most significantly, borrowers no longer need to worry about the totality of the circumstances test that was hard to employ without the benefit of legal counsel and sometimes intense factual development. But interpretive questions remain, especially for “close relatives” with an identity of economic interests.
1 The SBA’s Supplemental Interim Final Rule updated the SBA’s Interim Final Rule (which the SBA now sometimes calls its “Initial Rule”) released on April 2, 2020.
2 Consistent with the CARES Act, the Updated Affiliation Guidance waives the application of affiliation rules for (i) any business concern in the hospitality and dining industry designated as such under Sector 72 of the North American Industry Classification System that employs not more than 500 employees, (ii) any business concern operating as a franchise that is assigned a franchise identifier code by the SBA and (iii) any business concern that receives financial assistance from a SBIC. (CARES Act § 1102(b)(D)(iv).
3 The last sentence of section 1102 of the CARES Act provides: “On and after the date of enactment of this Act, the interim final rule published by the Administrator entitled “Express Loan Programs: Affiliation Standards” (85 Fed. Reg. 7622 (February 10, 2020)) is permanently rescinded and shall have no force or effect.”