The Small Business Administration has released draft questionnaires for review of paycheck protection program loan forgiveness applications of $2 million or more. Lewis Horowitz and Eric Kodesch of Lane Powell analyze the forms and see problems with the approach the agency is taking including a presumption of foresight by borrowers.
The Small Business Administration (SBA) has released draft questionnaires (one for for-profit businesses and one for non-profit businesses) for use in its review of paycheck protection program (PPP) loan forgiveness applications of PPP loans of $2 million or more. We applaud the SBA for sharing the draft forms because it allows the SBA to receive and consider comments from the public before finalizing.
However, these drafts provide troubling insight into the SBA’s approach to its review. In particular, many of the questions imply that the SBA will use financial results subsequent to the PPP loan application or disbursement date to assess whether the borrower made the “uncertainty certification” (also called the “necessity certification”) in good faith. That is, the SBA appears to replace uncertainty about what will happen in the future with the 20/20 hindsight we now have. Although this is a worrisome development, we do not know how the SBA will use the responses in reviewing a PPP borrower’s uncertainty certification. More importantly, the CARES Act explicitly required PPP borrowers to certify about “the uncertainty of current economic conditions.” We do not believe that the law allows the SBA to retroactively apply the then-unknown economic conditions that developed in making a forgiveness determination and we expect court challenges if the SBA does so.
Congress created PPP loans as a way to provide desperately needed stimulus for the economy. As the economic turmoil from the Covid-19 pandemic unfolded, Congress considered the record-setting unemployment figures, together with the potential for a devastating recession, and concluded that PPP loans were the best way to preserve the economy for a post-Covid-19 recovery. Elected officials and the press frequently emphasized that the “Paycheck Protection Program” was designed to protect paychecks of hard-working Americans. While true, Congress also protected landlords and the banks that financed commercial and industrial real estate. Indeed, with the amendment by the Paycheck Protection Program Flexibility Act (PPPFA), up to 40% of PPP loan forgiveness can be attributed to amounts paid for rent, mortgage interest, and utilities.
PPP applicants made several representations, including the uncertainty certification:
“Current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.”
This certification became the focus of a public (or at least journalistic) outcry when Shake Shack, Ruth’s Chris, and Potbelly, all publicly-held restaurant chains, received PPP loans, even though Congress specifically turned off the affiliation rules to allow chain restaurants (and hotels) to qualify for such loans. The SBA and Treasury Department could have responded to the press reports by noting that employees of these restaurant chains faced layoffs just like employees at the corner diner. Instead, the SBA on April 23 reinterpreted the uncertainty certification to generally mean that publicly-traded companies should rely on other access to capital—notwithstanding that the CARES Act expressly precluded any such lending criteria (presumably to override such requirement in the existing SBA 7a lending program). Shortly thereafter, the press learned that the family-owned Los Angeles Lakers had also applied for a PPP loan. The SBA quickly expanded the list of potential borrowers for which such certification was inappropriate to include those businesses owned by really wealthy individuals, as we described here.
The SBA apparently was not concerned with the cost of such other capital access, including dilution of the existing shareholders, or the ability of business owners to shut down and furlough employees rather than fund operations. In our view, the SBA was simply responding to press reports critical of the demand such borrowers were placing on allocated PPP funds at a time when there were legitimate fears that such demand was squeezing out smaller borrowers. (Congress ultimately increased the allocation for the PPP to a point that PPP funds actually went un-borrowed at the termination of the (extended) application period.)
On May 13, the SBA eased some concerns about the uncertainty certification by updating its PPP Loan FAQs to add FAQ 46. As we previously discussed in connection with FAQ 46, the SBA deemed all PPP borrowers with PPP loans under $2 million to have made the uncertainty certification in good faith. Such regulatory presumption seemed to be based on political and logistical considerations rather than an actual assessment of any facts (especially since administrative decisions seemed to be made ad hoc by Treasury Secretary Mnuchin on Sunday morning during his talk show circuit).
Indeed, if the SBA actually considered any economic information in setting that threshold, it certainly never communicated to the public or Congress that it collected or used that data when deciding that all loans below $2 million were kosher. Query whether a court might conclude that the failure to even reference, much less analyze, such data might be per se evidence of an arbitrary and capricious administrative action. To the extent the SBA claims exigent circumstances of the global pandemic necessitated immediate action to encourage small borrowers to feel more comfortable making the necessary certification, the SBA would have a hard time explaining why the same fears and circumstances should not equally apply to employers with larger payrolls.
We continue to believe that there is little justification to think that businesses with a 2019 average monthly payroll of less than $800,000 (the amount necessary for the borrower to receive a $2 million PPP loan), would have more uncertainty about current economic conditions than businesses with average monthly 2019 payrolls over $800,000.
In FAQ 46, the SBA also stated that the forgiveness applications for PPP borrowers with loans of $2 million or more “will be subject to review by SBA for compliance with program requirements set forth in the PPP Interim Final Rules and in the Borrower Application Form.” At the time, we did not know the scope of this review or the standards that would apply.
That Was Then, This Is Now
On October 26, the SBA released a notice that, in part, referenced the two new draft forms:
- SBA Form 3509—Loan Necessity Questionnaire (For-Profit Borrowers)
- SBA Form 3510—Loan Necessity Questionnaire (Non-Profit Borrowers)
These drafts start with questions about the activity of the business. We note the following in this category:
- Question 1 asks about gross revenue in 2020Q2 and 2019Q2 (or 2020Q1, if the business did not exist in 2019Q2). This question implies that the SBA believes an actual drop in 2020Q2 gross revenue compared to 2019Q2 gross revenue is relevant to the uncertainty certification. The uncertainty certification, however, concerned uncertainty so that an actual drop in revenue—or even an increase—should not be relevant when assessing whether the borrower made the uncertainty certification in good faith. Indeed, for companies that normally receive payment 30-60 days after delivering services or products, the impact of Covid-19 might not even implicate revenue until 2020Q3. Further, focusing on whether there was a drop in revenue in 2020Q2 disregards the impact on the pipeline for future projects. For example, the 2020Q2 cash flow for many businesses derived from pre-Covid 19 projects that were approved and budgeted. Those businesses might not experience a drop in 2020 revenue until Q4 or even until 2021.
- Questions 2 and 3 (for-profit) and Questions 4 and 5 (non-profit) focus on shut down “orders” and other “orders” that significantly alter operations, with specific questions about when the orders ended. This ignores the uncertainty businesses had at the time of the PPP loan application about the scope and impact of existing or future orders. This also could be problematic for businesses in states with less restrictive orders that took the same precautions as businesses in states with more restrictive orders based on health concerns, including those that did so because they feared liability. The draft forms capture this in the next two questions, but the use of the word “voluntarily” in those questions is concerning. We would not characterize changes prompted by health concerns for employees or customers as “voluntary.” In addition, the nature of the question disregards the uncertainty that businesses had about the ability of employees to efficiently work remotely or what would happen if a large number (or even a few key) employees became ill or had to miss work to care for family members who became ill.
- Question 6 (for-profit) and Question 8 (non-profit) concerns new capital improvements not due to Covid-19. This potentially punishes businesses that continued with capital projects that were approved before the pandemic. These projects are presumably necessary for the long-term vibrancy or viability of the business—or their managers would not have pursued them in the first place. It would not make sense for a business to shift money away from these projects to pay forgivable costs if doing so could materially harm longer-term prospects or would trigger material delays or termination costs.
- For example, if a business was planning to add a new production line that would not be placed in service for another year, or was developing a new product that would not be launched for another year, was the business supposed to cease such capital spending?
- It seems clear to us that one purpose of the PPP was to encourage businesses to continue to spend money so that the economy could easily restart as soon as the pandemic subsided.
The draft forms then move on to questions concerning liquidity assessment. We note the following in this category:
- Question 2 (for-profit; no corollary for non-profit) asks about dividends or other capital distributions during the covered period for incurring forgivable costs. At first blush, this question appears to make sense: businesses that distributed earnings in excess of taxes might reasonably expect that the SBA would question whether management was really concerned about Covid-19-related economic uncertainty.
- However, we hope the SBA will recognize that distributions do not mean that the management did not have legitimate and honest uncertainty at the time of the PPP loan application. For example, a business that, at the time of the application, did not anticipate making distributions because of the uncertainty, may have discovered that it could make distributions because the uncertainties did not arise. Alternatively, a business might have declared a dividend or distribution before the pandemic began and found itself in a position where it could not reverse the prior decision. Or the business owners may have relied on regularly scheduled dividends to satisfy their own financial commitments. In short, the world is complicated and the question appears to ignore the nuances of such complexity.
- Question 3 (for-profit) and Question 2 (non-profit) ask about prepayment of any outstanding debt, defined as “paid before contractually due.” It is unclear how to apply this question to a line of credit that usually lacks scheduled amortization.
- Many PPP borrowers borrowed on their lines of credit without an immediate need, in case the pandemic caused banks to reduce their lines or the borrowers fell out of loan covenants (exactly what happened to many borrowers during the 2007 recession). In our view, borrowing on a line before the business needed the funds demonstrates the uncertainty these businesses had about current economic conditions. Repaying those draws after the business had a better view of the Covid-19 impact on their operations does not suggest that the business lacked uncertainty.
- We know of some business owners who demanded that the business pay down other debt prematurely because the owners had guaranteed the business’s debt. Some owners threatened to withdraw their guarantee (to the extent permitted under the applicable loan agreements), which would have limited further draws or triggered defaults/accelerations. Guarantors concerned about the increased risk from the pandemic could—and often would—have placed those businesses in untenable positions. Once those businesses had a PPP loan, the business could continue operations with less risk to their owner’s personal assets, thereby avoiding the need to reduce employment or negotiate rent abatements or mortgage forbearance to protect the guarantor.
- By asking this question, the SBA seems to suggest that the uncertainty certification of these borrowers may now be suspect even though they paid down other debt precisely because of Covid-19-induced economic uncertainty.
- Questions 4 and 5 (for-profit; no corollary for non-profit) appear to punish businesses with employees who earned more than $250,000, annualized, during the covered period. We find it especially puzzling that the SBA does not ask about a comparison to 2019. We do not think that having employees who earn more than $250,000 should be a factor in judging the borrower’s uncertainty about economic conditions.
- The question implies that firms with employees earning over $250,000 should have convinced those employees to take pay cuts. Many did so but not everyone had that flexibility given the market demand for non-fungible contributors. Further, expecting businesses to do so would have undermined a key purpose of the PPP itself: to encourage businesses to maintain their workforce so that the economy could restart more easily when the pandemic subsided. In any event, suggesting now that businesses should have demanded concessions from their most highly compensated employees in lieu of securing a PPP loan strikes us as a “refinement” too late to add to be considered evidence that the borrower lacked the requisite uncertainty or need.
- Further, if the inquiry is relevant to for-profit businesses, it would seem to be equally applicable for non-profits, which raises the question of why the SBA did not include the same question on the questionnaire for non-profit businesses. This disparate treatment raises equal protection concerns if the SBA uses the answer to this question to deny PPP loan forgiveness for a for-profit PPP borrower.
- The CARES Act itself focused on employees earning over $100,000/year and expressly limited protections for them when computing the amount of a PPP loan eligible for forgiveness. We are confused as to why the SBA would now add a new category of highly compensated employees or why the treatment of that group is probative about the borrower’s uncertainty. Businesses with highly-compensated employees can also be fragile and their viability could be materially threatened by the loss of one or more key employees, especially at a time when competitors may be trying to recruit valued players.
- Question 12 (for-profit) and Question 10 (non-profit) concern whether the PPP borrower received “any funds from any CARES Act program other than PPP, excluding tax benefits.” Qualifying for a different CARES Act program should not impact the uncertainty certification for a PPP loan. Further, those other programs often were designed to provide additional focused assistance to certain troubled industries and to help fund costs that do not result in PPP loan forgiveness, such as personal protective equipment or because the business was in the travel industry.
- Most of the other CARES Act benefits were obtained weeks or even months after the PPP borrower made its uncertainty certification.
- Further, why should some CARES Act benefits be targeted for scrutiny while other very large stimulus benefits delivered in the form of tax changes, like enhanced absorption of net operating losses, be ignored.
Questions Should Meaningfully Inform any SBA Follow Up
We do not believe the draft questionnaires will provide information useful for assessing whether PPP borrowers made the uncertainty certification in good faith.
In addition, the SBA’s draft uncertainty certification questionnaires indicate that the SBA will approach each borrower’s uncertainty certification with suspicion and possible predisposition against the reasonableness of the borrower’s subjective concerns at the time they applied for the loan. In our experience, virtually all borrowers with whom we spoke were legitimately concerned about how the pandemic would affect them, and those that did not have serious concerns did not apply for a PPP loan (or returned their PPP loan).
Borrower concerns included how the pandemic might unfold and affect their employees’ ability to work, their customer’s ability to consume or need for their services, their supply chains, and the impact on their receivables if their customers couldn’t timely pay invoices when presented. As we all know now, many businesses have actually remained stable or even thrived for various (and sometimes unforeseeable) reasons. This does not mean these businesses lacked uncertainty about economic conditions. The SBA should not use that subsequent success to assess the economic uncertainty existing at the time the business submitted its PPP loan application. On the contrary, the SBA should view that success as a result of the flexibility provided by the PPP.
Further, for many businesses, success or failure of their business model pivot or customer repositioning will be measured not in one fiscal quarter, but in years—as they learn how to operate in this new global environment and whether they can further adapt to accommodate how the pandemic has impacted their customers, tenants, subcontractors, employees, recruitment capability, business development, or supply chains in ways that may not yet be apparent because of the long lead time in which those decisions unfold. Many of the businesses with whom we speak remain concerned to this day. If the SBA does consider a borrower’s post-PPP application success as evidence that the business lacked sufficient uncertainty, then we look forward to representing clients in the appeals process the SBA detailed in its 23rd interim final rule.
It is certainly reasonable for the SBA to ask PPP recipients to explain the basis for their good faith belief that, when securing their PPP loans, the current economic uncertainty made the loan request necessary to support the ongoing operations of their business. We think the SBA would be better served by asking explicitly for such information. For example, the SBA could request any internal assessment prepared by management that supports the certification. If the borrower did not prepare a written assessment at the time, then we think it reasonable for the SBA to ask the borrower to now explain their reasons why they felt comfortable making the referenced certification. Either way, the inquiry would focus on each borrower’s subjective assessment of uncertainty that could be used to assess bad faith by an objective SBA. Such questions would shed better light on the core inquiry without the need for tens of thousands of borrowers to answer questions whose purpose is hard to fathom.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Source: Bloomberg Tax