COVID-19 Response: CARES Act Paycheck Protection Program for Small Business Loans - Slightly New Guidance on the Affiliation Rules
Washington, D.C. (April 6, 2020) - As small business borrowers and their counsel scramble to understand the rules governing eligibility for the low interest small business loans in the CARES Act, questions on how the “affiliation rules” will apply have come up over and over again. These rules require that would-be loan applicants under the Paycheck Protection Program (PPP) must count employees from affiliated entities in determining whether a business has fewer than 500 employees and is therefore eligible for a loan and, even more importantly, loan forgiveness.
The CARES Act waived the affiliation rules for franchisees and limited other types of businesses, but left the rules in place for most entities. The Small Business Administration (SBA) promised it would clarify the applicability of the affiliations rules under the PPP, but its April 3, 2020 Interim Final Rule confirmed only that religious institutions need not worry, and left private equity and venture capital firms wanting more. The guidance reiterates that applicants to the SBA’s Business Loan Program, which includes PPP, are subject to the affiliation rule contained in 13 C.F.R. § 121.301, and businesses with complex financial structures will need to look carefully at these rules to determine their eligibility for PPP loans.
Summary of the Four Affiliation Tests – Requirements of Section 121.301
In a partial advance for venture capital concerns, the April 3 guidance clarified that the more restrictive rules at 13 C.F.R. §121.103 do not apply. Nevertheless, those in §121.301 will still exclude from the PPP many startup and portfolio companies with fewer than 500 employees.
Affiliation under any of the four circumstances described below is sufficient to establish affiliation for purposes of application for PPP loans:
- Affiliation Based on Ownership or Control. Any individual, concern, or entity that owns or has the power to control more than 50% of the voting equity is considered an affiliate. The SBA will deem 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.
- Affiliation Arising Under Stock Options, Convertible Securities, and Agreements to Merge. In determining size, the SBA considers stock options, convertible securities, and agreements to merge to have a present effect of the power to control, unless those agreements are open or under negotiation. The SBA, however, will not view as affiliated stock options, convertible securities, and agreements to merge that are subject to conditions precedent that are “incapable of fulfillment, speculative, conjectural,” or “unenforceable” under law.
- Affiliation Based on Management. Affiliation is assumed where an applicant business’s President, CEO, or other officers, managing members, or partners who control the management of the business also control the management of one or more other entities.
- Affiliation Based on Identity of Interest. Affiliation occurs when there is an identity of interest between close relatives, such as where the close relatives operate a business in the same or similar industry in the same geographic area.
A New “Religious Exemption”
The newly issued guidance provides a blanket exemption from the affiliate rules for faith-based organizations. Under the exemption, a faith-based organization will not be considered affiliated with another organization if the relationship is based on a religious teaching or belief or otherwise constitutes a part of the exercise of religion.
Statutory Waivers Remain the Same
Section 7(a)(36)(D)(iv) of the Small Business Act (15 U.S.C. § 636(a)(36)(D)(iv)), added by the CARES Act, waived the affiliation rules for three limited categories: (1) any business concern with not more than 500 employees that, as of the date on which the loan is disbursed, is assigned a North American Industry Classification System (NAICS) code beginning with 72 (food and hospitality industry sector); (2) any business concern operating as a franchise that is assigned a franchise identifier code by the SBA; and (3) 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). The newly issued affiliation rules have no effect on these statutory waivers, which remain in full force and effect.
The scope and interpretation of the affiliation rules continue to challenge many businesses interested in seeking relief under the PPP, particularly portfolio companies and startups with complex financial arrangements. These entities will need to assess their structures carefully to determine eligibility for PPP loans and forgiveness. For more information, contact the authors of this alert. You can also visit our COVID-19 Response Resource Center for more alerts on this topic.
Karen C. Bennett, Partner
Katherine I. Funk, Partner
Jane C. Luxton, Partner
Soo Jin K. Isicoff, Associate