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April 6 2020

Client Alert - SBA Releases Interim Final Rule Regarding Affiliation, Adding Clarification to Which Businesses Qualify for Payroll Protection Program Based Upon Size

By: Michael J. Huff

Among the most discussed relief created by the CARES Act is the Paycheck Protection Program (“PPP”) which makes funds available for businesses with less than 500 employees and certain other qualifying businesses.  Most borrowers are expected to be eligible for forgiveness of the balance of their loan to the extent at least 75% of the loan is used to cover payroll and the remaining amounts are used to cover rent, mortgage interest, and utility expenses from arrangements which were in place prior to February 15, 2020. 

Late Friday, the SBA published an interim final rule (the “Interim Rule”) defining the affiliation rules applicable to PPP loans.  As provided in the Interim Rule, most borrowers will be considered together with their affiliates for purposes of determining eligibility for a PPP loan.  Thus, it is important borrowers with affiliated entities understand how the affiliation rules apply to them to determine if they are eligible to participate in PPP.

Some of the SBA’s traditional affiliation tests, which are generically described below, are deemed to apply to PPP loans:

  1. Affiliation based on ownership – As a general rule, a potential borrower is deemed to be an affiliate of any party which owns or has the power to control more than 50% of the potential borrower.  When no party has control over the equity interest of a borrower, then either the board of directors or president of the potential borrower will be deemed to be in control.  Additionally, minority shareholders can be deemed to control a potential borrower if such shareholder has the ability to prevent or block action by the board of directors or shareholders.
  2. Affiliation arising under stock options, convertible securities, and agreements to merge – The SBA considers stock option, convertible securities, and agreements to merge as though such options, convertible securities, and agreements have been exercised for purposes of determining if a party has the power to control a potential borrower.
  3. Affiliation based on management -  When the president or CEO of a potential borrower controls the management of one or more other parties, or a single individual or entity controls the board of directors or management of both the potential borrower and another entity, affiliation is deemed to arise.
  4. Affiliation based on identity of interest – When a spouse, parent, child or sibling, or the spouse of any such person has identical or substantially identical business interests, the interests may be aggregated.

Under the Interim Rule, certain entities which would typically be subject to affiliation rules are exempt, including the exemptions set forth within the Cares Act which include the accommodation and food services sector, franchise businesses, and certain small business investment companies.  Additionally, faith-based entities are generally exempt from affiliation rules under PPP.  There is some ambiguity regarding the extent to which nonprofit entities may be subject to affiliation rules.  The SBA Interim Rule indicates nonprofits are generally not subject to the affiliation rules set forth within the current regulation cited to within the provision of the CARES Act stating the nonprofit entities would be subject to affiliation rules.  This ambiguity may or may not be resolved in the future but should be monitored by nonprofit entities.

The ultimate impact of the Interim Rule is that certain potential borrowers may need to amend existing stock options, control agreements, and other arrangements to avoid being deemed to have too many employees under the affiliation rules if the survival of a potential borrower is dependent upon obtaining a PPP loan.  Further, legal relationships which often govern the investments venture capital and angel investor funds make in start-up ventures will need to be examined on a case-by-case basis for compliance with affiliation rules.

Contact your attorney to discuss any current stock options, control agreements, and other like arrangements to determine if an amendment is necessary for your company to qualify for a PPP loan.