In light of the rapidly changing coronavirus (COVID-19) situation, Troutman Sanders and Pepper Hamilton have postponed the effective date of their previously announced merger until July 1, 2020. The new firm – Troutman Pepper – will feature 1,100+ attorneys across 23 U.S. offices. Read more.
In a very short period of time, private equity groups and their portfolio companies have had to deal with an unprecedented amount of change in response to the novel coronavirus (COVID-19) crisis. Pepper Hamilton is working diligently in response to these events and has developed guidance on many of the issues that you may soon face, or indeed may already be facing. The guidance offered below takes into account developments as of today, but, as the situation continues to develop, the guidance will need to evolve as well. Furthermore, your particular facts may or may not easily fall within the guidance discussed below.
Your advisers at Pepper Hamilton are available to talk with and help you through these issues as they arise. If you have questions or would like to discuss any of the items covered below further, please reach out to:
Bruce K. Fenton (215.981.4646, email@example.com)
Joseph F. Kadlec (215.981.4260, firstname.lastname@example.org)
Daniel W. McDonough (610.640.7821, email@example.com)
Donald R. Readlinger (609.951.4164, firstname.lastname@example.org)
The Private Equity Practice Group contributors to this resource are Christopher A. Rossi, Michael A. Temple, Mark T. Wilhelm, Matthew Giannascoli, Laura M. Kleinberg, Yueyang (Sophie) Zhang, Valerie V. Cruz Martinez, Dawn Hall (Corporate and Securities); Joan C. Arnold, Howard S. Goldberg (Tax); Todd A. Feinsmith, Deborah Kovsky-Apap (Restructuring and Bankruptcy); Barbara T. Sicalides (Antitrust); J. Bradley Boericke, Lisa D. Kabnick, Kathryn P. Nordick, Deborah J. Enea (Financial Services); and Susan K. Lessack, Tracey E. Diamond (Employment).
Please also refer to the broader Pepper Hamilton and Troutman Sanders joint COVID-19 Resource Center for additional information in response to the ongoing crisis.
It seems inevitable that one of the employees of our firm or one of our portfolio companies will test positive for COVID-19. What do we do? What if the person is still being tested or just exhibiting COVID-19 symptoms?
When there is an emergency situation such as this one, can the directors of our portfolio companies suspend their fiduciary duties? If not, should directors act differently in order to fulfill these duties?
Our portfolio company’s revenues are at risk as a result of the COVID-19 crisis. What can we do to protect our interests and ensure there will still be a company when we come out the other side? Should we wait for our lenders to come to us?
Health and Employee Matters
Q: It seems inevitable that one of the employees of our firm or one of our portfolio companies will test positive for COVID-19. What do we do? What if the person is still being tested or just exhibiting COVID-19 symptoms?
A: Obviously, this situation has evolved rapidly and continues to do so. We will make every effort to update this information when appropriate. The information below incorporates current guidance from the Centers for Disease Control and Prevention (CDC), but it is not intended to be a substitute for professional medical advice, diagnosis or treatment. To help you navigate your particular circumstances and the considerations referenced below, as well as assist with certain workplace management issues that may arise, we have prepared Employment FAQs.
If an employee comes to work displaying COVID-19 symptoms or informs you that the employee has come in contact with an individual diagnosed with COVID-19, stay calm. Immediately separate the employee from other employees and send the employee home to self-quarantine for 14 days. If the employee becomes ill with COVID-19, the employee should not return to work until the employee has been fever-free without the use of medication for at least three full days, the employee’s other symptoms have improved and either at least seven days have passed since the employee’s symptoms first appeared or, if the employee is tested to determine if he or she is still contagious, the employee has received two negative tests in a row, at least 24 hours apart. If the employee came into close physical contact with other employees during their time in the workplace (i.e., a distance of less than six feet), send those employees home to self-quarantine for 14 days. If any of those employees become ill with COVID-19, those employees should not return to work until they have been fever-free without the use of medication for at least three full days, the employee’s other symptoms have improved and either at least seven days have passed since the employee’s symptoms first appeared or, if the employee is tested to determine if he or she is still contagious, the employee has received two negative tests in a row, at least 24 hours apart. Employers also should conduct a deep clean of the ill/potentially ill employee’s workspace.
Employers should not reveal the identity of the infected employee unless the infected employee has provided permission to share his or her name (which you can ask, but not require, him or her to provide) because, like with any illness, the reason for an employee’s absence is confidential and should not be shared with others. Depending on the nature of your workplace, you want to inform any potentially exposed customers, vendors and/or other building tenants. If you feel it is critical for safety reasons to identify the employee in notifying others or working to determine who may have been exposed, or if the identity will be obvious once the notification is made, please give us a call and we can discuss.
If an employee is being tested for COVID-19 or has already tested positive for COVID-19, report the matter (without identifying the employee) to the applicable local health board. The local agency may have its own protocols to follow, with which you should comply.
Bear in mind as you are going through this situation that — even though you may be trying to help and to ensure the safety of others — employers cannot treat people differently based on their age, gender, pregnancy, whether they have an underlying health condition, or any other protected category. If an employee asks to work from home because he or she is in a high-risk category, as defined by the CDC, then the employer may (but is not required to) grant that request. Conversely, an employer may encourage or require employees to telecommute to control the spread of COVID-19. Many companies are making plans to have at least some of their workforce telecommute in the event that the virus impacts their ability to come to work, and some employers already have mandated a telecommuting practice. Additionally, allowing a sick employee to work remotely in lieu of taking time off may be considered a reasonable accommodation for a disability under the Americans with Disabilities Act (ADA) if the employee can perform the essential functions of his or her job while telecommuting. Note, however, that the ADA does not require employers to lower quality or productivity standards as a reasonable accommodation. Our colleagues at Troutman Sanders have prepared Employer Guidance if you have determined to send employees home or are implementing remote work policies.
In our Employment FAQs, we describe our guidance as to other workplace questions that are becoming more common, including whether an employee is entitled to wear a face mask, whether the employer can take an employee’s temperature at work, whether the employer may inquire about recent travel, obligations to grant time off for family-related matters resulting from COVID-19, issues relating to short-staffed operations, unemployment benefits, and the possibility of furloughs.
The Occupational Safety and Health Administration (OSHA) has published Guidance on Preparing Workplaces for COVID-19 for other workplace safety tips. In addition, on March 18, President Trump signed the Families First Coronavirus Response Act (which becomes effective on April 1), a law that includes the Emergency Paid Sick Leave Act (EPSLA). Under the EPSLA, employers with fewer than 500 employees will have to provide 80 hours of paid sick leave to full-time employees (and a prorated number of days to part-time employees) for specified reasons related to COVID-19. Furthermore, the Families First Coronavirus Response Act includes amendments to the Family and Medical Leave Act providing for partial pay for eligible employees who cannot work or telework because they are taking care of dependent children because of school closures. The implications of this law, particularly given the number of jurisdictions that are facing government-mandated shutdowns, are far-reaching, and we are available to discuss the impacts to your business in this evolving legislative landscape. Other federal or state laws remain under deliberation. As such, additional or different regulations may be introduced in the near future. (Back to the Top)
A: The decision of whether to close any given office will depend on several factors, including whether federal, state or local governments have imposed restrictions on that office remaining open, as well as best practices that are independent of regulators. You may have to consider whether your business is “essential,” as we have been tracking in “Whether Your Business Is Essential.”
State and local governments have been the most active governmental bodies in mandating that businesses close due to COVID-19 concerns, and their regulations have varied widely. However, common factors in these regulations have been the nature of the business; whether the business has been deemed “essential,” “nonessential,” “life-sustaining” or another similar designation; and whether the state or local government’s policies are mandatory or permissive. Regulations on business closures are constantly changing and are sometimes subject to conflicting “clarifications.”
Even where mandatory shutdown regulations are in place, there may be an allowance for skeleton crews to remain on-site to ensure IT functionality for remote access. In addition, many jurisdictions have a process through which businesses can apply for a waiver from closure restrictions to continue to operate on-site.
Regardless of governmental regulation, each management team should also consider whether its business is following best health and safety practices if it decides to remain open for business. That evaluation should include whether it is possible both to maintain best practices in offices and other business spaces regarding social distancing and to keep those spaces clean and sanitary. Although a number of businesses that remain open have made on-site attendance voluntary, companies remaining open (even on a voluntary basis) have a responsibility to follow these best practices. The failure to do so could lead to liability for your company. (Back to the Top)
A: Since COVID-19 has required many companies to function with a remote workforce, there are a number of items to consider moving forward. Above all, an organization should consider whether its current IT infrastructure can allow its business to continue to operate with a completely or predominately remote work force. It should also determine what challenges a surge in employees working remotely will present, including a decrease in IT support staff and an increased dependence on certain information technology and bandwidth.
Steps also need to be taken to ensure that an organization’s data and IT infrastructure is secure. As Troutman Sanders has detailed, an organization should (1) encourage employee awareness for cybersecurity matters that can arise in remote working environments, (2) implement policies and practices to encourage securing remote work environments, (3) reconsider whether remote access by vendors with access to protected information is appropriate or should be modified, (4) update incident response plans, and (5) review cybersecurity insurance policies. An organization should also be prepared for an increase in certain cybersecurity attacks, and we have considered ways to reduce cybersecurity attacks, recommending training and other methods to combat targeted cybersecurity attacks.
Finally, now that your employees are scattered in ways possibly never contemplated, we recommend considering the extent to which additional business registration, local employment tax or sales and use tax filings may be necessary in additional states. (Back to the Top)
A: The first consideration many clients are interested in is whether or not this crisis can be considered a “material adverse effect.” This is the subject matter of the next Q&A below. Other executory period considerations include:
“Ordinary Course” Covenants. Virtually all purchase agreements contain provisions that require the seller to operate the business being sold in the “ordinary course” between signing and closing in order to ensure that the business to be acquired is preserved and not adversely altered by the actions of the seller. Because the language of these covenants is not standardized and can vary from purchase agreement to purchase agreement, careful attention must be paid to the specific requirements of the relevant language in your purchase agreement. Although force majeure clauses are more common in supply agreements than they are in purchase and sale contracts, to the extent your purchase agreement contains such a clause, we have specifically analyzed whether these clauses may provide a party relief for failing to perform pre-closing covenants.
Sometimes, the “ordinary course” covenant is also accompanied by a specific list of prohibited acts for which a seller must obtain buyer’s consent before undertaking. Extraordinary situations (such as the COVID-19 crisis) do not relieve sellers of this obligation. As such, sellers should follow the requirements of the purchase agreement and seek the consent of a buyer when required (and any such consent should be memorialized in writing). Buyers should keep in mind that there is often a common law obligation to act reasonably and in good faith unless that standard is modified by the purchase agreement. If the buyer refuses to grant a requested consent, sellers should consult counsel in order to analyze the specific situation before any further action is taken.
It is important for officers and directors also to be mindful that they must continue to comply with their fiduciary duties, and that compliance with those duties may dictate a course of action that would conflict with the company’s contractual obligations. For example, assume that the “ordinary course” covenant in a purchase agreement prohibits the incurrence of debt without the buyer’s consent. During this crisis, it may be necessary to incur additional debt in order to maintain adequate cash. Even if the buyer’s consent to this incurrence cannot be obtained, the board’s fiduciary duties may, depending on the circumstances, require such incurrence.
In these difficult circumstances, where the specific facts of the situation and language of the agreement need to be carefully evaluated, consultation with legal advisers can be critically important.
Updates to Schedules. Another critical provision to examine regards the ability of the seller to update disclosure schedules before closing, and what the effect of these updates (if permitted) will be. If the seller has the ability to update schedules, it increases the likelihood that the seller’s representations will be accurate at closing and thus the buyer’s conditions to closing will be met. However, in some cases, even though the seller can update schedules and force the buyer to close, the seller will still be responsible for pre-closing breaches under the indemnity provisions as if the updates never happened. (Back to the Top)
A: Although the answer to this question depends largely on the language of the “material adverse effect” definition within the purchase agreement, it is unlikely under Delaware law that the COVID-19 outbreak (or its collateral impact on markets) would constitute a material adverse effect under typical formulations of that definition. Common definitions of “material adverse effect” often exclude (1) economy-wide or market-wide changes, (2) pandemics or infectious diseases, and (3) catastrophic force majeure events, which all have the effect of shifting the general market risk to the buyer during an executory period.
That said, under the typical definition, a material adverse effect may still occur if the target is disproportionately impacted by those events as compared to similarly situated participants in the target’s industry, shifting the specific market risks back to the target. In other words, under typical definitions, in order for a target to suffer a material adverse effect, COVID-19 would need to disproportionately affect a particular target’s business as compared to other industry participants. This disproportionate impact is unusual at best, and, even if arguably occurring, there remains a high burden on a buyer to prove the disproportionate impact, given the widespread and systemic impacts that COVID-19 is having on the economy in general.
Notwithstanding the foregoing, under Delaware law, a material adverse effect will be found to have occurred only when the target suffers a financially adverse impact that is both (1) material and (2) durationally significant. With respect to materiality, Delaware courts will compare EBITDA generated by the target in the quarters following the event that caused the purported material adverse effect with the EBITDA generated by the target in the corresponding reporting period. Given the negative economic impact COVID-19 has had on the financial performance of companies across the world, it is certainly possible that a target’s negative financial performance could meet the materiality threshold under Delaware law. However, more is required to constitute a material adverse effect; the financially adverse impact must also substantially threaten the overall earnings potential of the target in a durationally significant manner. A “short-term hiccup” in EBITDA will not suffice. Rather, the financially adverse impact must be expected to last, at a minimum, more than a year. The lack of clarity with respect to how long the COVID-19 pandemic will last, and consequently how its effects will be felt on a target and its business, means that the standard for durational significance is, at best, unclear at this time.
A: Although the competition enforcement agencies continue to operate, the process is certainly slowing down. The U.S. Federal Trade Commission and the U.S. Department of Justice will not grant early termination of the Hart-Scott-Rodino waiting period right now. The guidance from the agencies makes clear that many deals will likely take longer to get through the premerger notification process and the parties should consider more in-depth prefiling planning and analysis. Premerger filings must be made electronically, but hard copy documentation will be necessary after the resumption of normal agency operations. Consider adjusting risk allocation and premerger notification coordination obligations in your purchase agreement to take into account the likely delay, including possibly extending relevant “outside dates.” Also consider the type of material that is being prepared and delivered, given the likely remote work situations in which even reviewers will find themselves. We have analyzed Potential Considerations and more detailed strategies with our colleagues at Troutman Sanders, including considerations with respect to certain non-U.S. agencies. (Back to the Top)
A: The normal mechanics of closing any transaction or financing requiring the filing of documents with a governmental authority must be reevaluated as a result of the COVID-19 pandemic. In response to this crisis, the secretary of state and local county offices in many states have reduced or suspended the availability of their in-person counter service, and many other services these offices provide are also experiencing delays or have been cut off entirely due to reduced personnel. In a deal process, the services provided by the secretary of state are often utilized in multiple ways, including:
the formation of an acquisition vehicle used to serve as the purchasing entity in a transaction
the filing of certificates of merger, articles of dissolution, certificates of conversion and other documents required to complete a merger, F reorganization or other changes in corporate form and existence
obtaining certified charters, certificates of good standing and qualifications to do business
the filing of amendments to an entity’s charter or certificate of formation.
Fortunately, the services outlined above are offered online in many states, with varying response times for receiving the required service or document. For example, as of this writing, the Delaware Secretary of State is running business as usual for online filings and 24-hour turnaround times for certain services remain available. In Pennsylvania, although the Secretary of State offices are closed, services are available online; however, expedited service is not available and there is an extended delay in the receipt of evidence of filing. Illinois has closed all Secretary of State offices and has very limited online filing options — for example, certificates of merger cannot be filed online in Illinois and therefore cannot be filed until the offices reopen, which would prevent a merger transaction involving Illinois entities from closing until the offices reopen.
In sum, secretary of state office closures and service delays could cause delays in your transaction. Our service provider agents are tracking the current secretary of state office closures and other restrictions here, and we are monitoring for additional measures as well. Although the list is frequently updated, the information is constantly changing and available services vary greatly from state to state, so each applicable state should be checked in real time and confirmed. (Back to the Top)
Q: When there is an emergency situation such as this one, can the directors of our portfolio companies suspend their fiduciary duties? If not, should directors act differently in order to fulfill these duties?
A: There is no exception during times of crisis to a corporate director’s obligation to observe fiduciary duties. This applies to other entities as well, including managers of LLCs, general partners of partnerships, and trustees of trusts. (Note that some state laws, such as Delaware, permit the elimination of certain of a manager’s fiduciary duties to a Delaware LLC if so specified in the company’s operating agreement. This is a broader elimination of these duties that is not crisis-dependent and not at issue here). As such, director decisions need to continue to reflect the director’s good faith determination of what is in the best interest of the business. The answer to what is in the best interest of the business may be different in times of crisis, or it may be appropriate to “stay the course.”
If there is reason to believe that the company is insolvent (or if the company expects not to be able to pay debts that are reasonably foreseeable), directors should exercise particular caution. They can be held personally liable for shareholder distributions made by an insolvent company, and some states allow creditors to bring these claims directly. Creditors may also be able to bring claims to void transactions and claw back transfers. The key to protecting the private equity fund is for its nominees on portfolio company boards to (1) act in good faith, (2) be consistent in how issues are approached, (3) make decisions based on as much information as possible, and (4) document the rationale for decisions. One of the board’s primary responsibilities is overseeing management. Board members may want to consider increased frequency of board calls, or the designation of a special committee to address COVID-19 related matters, in order to hear from and provide direction to management to address rapidly changing circumstances. In times of crisis, the best protection against second-guessing with the benefit of hindsight is fulsome documentation in real time. (Back to the Top)
A: First, use this time to finalize any protocols and procedures should an actual direct health situation arise. In addition, use this time to review your material contracts and consider whether the company will be able to continue performance thereunder, or if it will only be able to do so in a diminished capacity. Consider the ability of the company’s counterparties to do the same. If you have a good relationship with the relevant business partner, consider if it is possible to negotiate revisions to the performance obligations to adjust to the practical reality. And further, consider the practical business interests of generally keeping customers and suppliers informed. To the extent that the company has to rely on the terms of an applicable contract, many of the force majeure provisions of contracts are being carefully scrutinized to determine if the COVID-19 crisis constitutes a basis for not being able to perform a contract, as we have discussed more broadly in an analysis of Force Majeure Clauses. (Back to the Top)
Q: Our portfolio company’s revenues are at risk as a result of the COVID-19 crisis. What can we do to protect our interests and ensure there will still be a company when we come out the other side? Should we wait for our lenders to come to us?
A: While there is no “one size fits all” advice in this type of situation, generally speaking, the first step is to take a hard look at the 13-week cash flow under the “new reality” scenario. Strip out every cost that is not absolutely essential or that can be reduced or deferred, including capital expenditures, vendors, rent and payroll. Seriously consider drawing down on any availability under your existing lines of credit. Even if such a draw down provides the company with adequate cash for an interim period, this is also the time to consider reaching out to lenders to restructure the company’s debt, even if only temporarily. Consider our more detailed thoughts on Restructuring in the Time of Coronavirus, and consider changes to the company’s borrowing base, reduction of interest, partial loan forgiveness, PIKing interest payments, establishing a temporary moratorium with deferred payments tacked on to the end of the loan, or splitting the existing debt into a senior/subordinated note structure. We expect that most lenders will be willing to work with borrowers that are proactive in seeking out short-term solutions, although they may be less willing to fund losses, particularly given the widespread breadth of the economic and health issues.
Should the company need to go down this path, the Bankruptcy Code gives a debtor breathing room from creditors under the automatic stay, and allows the debtor to confirm a plan of reorganization over the objections of nonconsenting creditors. Under some circumstances, existing equity holders are able to retain ownership of the debtor company even after bankruptcy, but forward-looking planning is critical. (Back to the Top)
A: The specific wording in the company’s loan agreements must be reviewed as the language of each such agreement is specific to the bank and borrower. Most EBITDA adjustments tie to specific items of gain or loss flowing through a company’s income statement, such as unusual or nonrecurring “losses” or “charges.” In many cases, there may be clauses that would allow add-backs for costs incurred to respond to the crisis — such as costs or charges related to office closings, to re-route or replace supply chains, or to implement work-at-home solutions. However, most EBITDA definitions do not readily provide any adjustments for the failure of revenue to come in the door, as will likely be the impact of COVID-19 for many businesses. As a result, we expect many borrowers will need to seek relief from their bank for noncompliance with their financial covenants. Even businesses with only “covenant lite” agreements may need to seek relief in order to pursue business initiatives conditioned on meeting certain financial metrics. (Back to the Top)
A: If the restructured debt constitutes a “significant modification” of the original debt for tax purposes (whether or not there is an actual exchange of debt instruments), the transaction is considered an exchange for tax purposes. Significant modifications can arise, for example, if there are certain changes in yield, principal amount, payment timing, obligor or security. Sometimes, the modifications can be so significant that what was debt is now considered as equity for U.S. tax purposes.
When the modification of the debt is a significant modification, it is possible that the borrower can have cancellation of debt income. If, however, (1) the debt is not publicly traded (which is a broad term), (2) the issue price of the old note is the same as the new note, and (3) each note provided for interest of at least the applicable federal rate, then there may not be any current impact. If the modifications include other components, such as the granting of warrants, a more technical analysis is needed.
A corporate debtor may offset 80 percent of its income, including cancellation of debt income, with prior years’ net operating losses (NOLs) to the extent the NOLs are not subject to limitation on use. A corporate debtor may exclude cancellation of debt income to the extent of insolvency or in its entirety in a federal bankruptcy case. To the extent cancellation of debt income is excluded under these circumstances, tax attributes of the corporation are reduced.
If the portfolio company is a tax partnership, the insolvency and bankruptcy cancellation of debt exclusions, as well as the related attribute reduction, are determined at the partner level (e.g., insolvency is present to the extent the relevant partner is insolvent).
Of note, a common fact pattern involves a party related to the portfolio company for tax purposes, such as the fund, acquiring the debt at a discount. In this case, the tax rules may result in cancellation of debt income to the debtor, with the debt deemed reissued to the fund with original issue discount. (Back to the Top)
A: In states where the ability to file UCC financing statements can be done online, the ability to file will remain unaffected. In states without online service, counter service has been widely suspended, so physical filing and retrieval of copies of UCC financing statements in those offices will be delayed until they reopen. Some secretary of state offices have set up drop boxes for physical filings, but it is unclear whether or to what extent these alternate filing measures will continue.
In all states, there is the ability to search for UCC financing statements online, so we do not expect that obtaining state-level UCC lien search results will be affected. Some counties have made their filings available online, so these should be checked on a case-by-case basis, especially if there are fixtures in the collateral package or specialty collateral that require filing against the collateral at the county level. (Back to the Top)
A: In most states (including, but not limited to, California, New York, Pennsylvania and Delaware) and the District of Columbia, electronic signatures have the same legal effect as manual signatures. Under federal law, an electronic signature can be any electronic sound, symbol or process that is attached to or logically associated with a contract or record, and executed or adopted with the intent to sign the record. If a law requires a signature, an electronic signature satisfies the law. However, these laws do not apply to certain commercial transactions. Negotiable instruments, such as negotiable promissory notes, mortgages and other instruments of title where possession of the instrument confers title, remain agreements that should not be signed electronically. Even if you come across a lender that has relaxed its standards for electronic signatures, you may need to ensure that you are not tripped up by local laws requiring express authority for how a document is signed (which would be covered in applicable authorizing board resolutions). For credit agreements, many lenders have historically continued to require ink-signed copies of signature pages. In this environment, however, lenders may start to permit electronic signatures on a case-by-case basis, but it is important to reconfirm a lender’s requirements directly and early in your process. (Back to the Top)
A: SBA operates a Disaster Loan Program that provides loans of up to $2 million to eligible small businesses. Congress is considering legislation that would expand the availability of SBA’s 7(a) Loan Program. This legislation is in the very early stages, and its provisions remain fluid. We are also tracking other programs and pending federal legislation, but programs and requirements vary widely. We are tracking progress and will provide an update when there is something definitive to report.
With respect to the SBA Disaster Loan Program, to be eligible, the company must:
be located in a designated disaster area
show that it has suffered substantial economic injury as a result of COVID-19, and
be a “small business.”
Substantial Economic Injury
The company must show that it has suffered substantial economic injury as a result of COVID-19. Substantial economic injury means the business is unable to meet its obligations and to pay its ordinary and necessary operating expenses. Economic Injury Disaster Loans provide the necessary working capital to help small businesses survive until normal operations resume after a disaster. Eligibility is also determined if SBA finds that the business is unable to obtain credit elsewhere. If SBA determines that private credit may be available to a business, the business may be deemed ineligible to receive a loan (or the loan amount may be reduced).
Company Must Be a “Small Business”
The company must be a “small business.” To be considered a “small business”:
the size of the company alone (without affiliates) must not exceed the size standard designated for the industry in which the applicant is primarily engaged, and
the size of the company combined with its affiliates must not exceed the size standard designated for either the primary industry of the applicant alone or the primary industry of the applicant and its affiliates, whichever is greater.
The size standards for the Disaster Loan Program make reference to the North American Industrial Classification System (NAICS) and are based on either the number of employees (generally 500 to 1,000 for manufacturers) or receipts, depending on the industry.
The concept of “affiliation” is important because the company may lose it “small” status if it is considered to be affiliated with other entities. 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.
Companies owned in whole or substantial part by funds licensed by SBA as “small business investment companies” (SBICs) are not considered affiliates of the SBIC. Thus, portfolio companies that may be controlled by an SBIC are not aggregated for purposes of determining whether a company is a small business for purposes of the Disaster Loan Program.
A: Assuming the company is a corporation for tax purposes, the most significant issue in such a case is the possibility of dry income — taxable income before cash is received. Dry income can arise if the interest yield is greater than the interest to be paid annually. This often happens where there is PIK interest in the loan or the loan is issued with an equity kicker like a warrant (the value of the warrant generally will reduce the issue price of the note, so there is additional interest in the note).
If the portfolio company is taxed as a partnership for U.S. tax purposes, there can be the following additional considerations: (1) if the loan goes bad, there will be cancellation of debt income in the portfolio company (treated as ordinary income) that is allocated up to the fund; (2) the fund takes a write-off on the loan, but the write-off is a capital loss, which cannot be used to offset the ordinary cancellation of debt income; and (3) advances to portfolio companies that are partnerships for U.S. tax purposes may be better off made in preferred equity. (Back to the Top)
A: If a fund invests in preferred stock of a corporation, there is some uncertainty as to whether accrued but unpaid dividends on the stock may be includible in income of the fund over time to the extent the corporation has earnings and profits. This will not be the case, however, if the company has the right to declare the dividend at any time that its board of directors decides, or if the preferred stock participates with the common stock in dividends and liquidating proceeds in a meaningful manner (i.e., the stock is “participating preferred”) or is not puttable, callable or redeemable (i.e., the stock is “evergreen”).
Further, if the fund invests in stock (or, in certain cases, equity derivatives or convertible debt) and the investment causes an “ownership change” in the corporation (generally, a greater-than-50 percent change in ownership based on stock value over the three years preceding the investment), NOLs of the corporation may be limited in use to offset future income. An ownership change analysis (under Internal Revenue Code section 382) should be considered in conjunction with any corporate equity infusion. (Back to the Top)
A: If the portfolio company is a partnership (including an LLC taxed as a partnership), the fund would need to consider the implications that (1) foreign partners of the fund will have U.S. taxable income (ECI) with respect to the portfolio company’s operations to the extent that income is considered “effectively connected” with a U.S. trade or business and (2) tax-exempt partners of the fund will have unrelated business taxable income, or UBTI, with respect to the portfolio company’s operations. Further, if the equity investment is an investment with a preferred return (e.g., an accruing percentage interest or multiple of original investment), depending on the waterfall and tax allocation provisions of the portfolio company operating agreement, the fund may be considered to have income without cash to the extent the preferred return is unsupported by allocated income (e.g., if the company is flat or earning little money to support the preferred return). (Back to the Top)
A: The most significant issue in this context is structuring the equity backstop to avoid having the debt treated for tax purposes as an obligation of the fund (i.e., the creditor should be looking to the company and not the fund for payment based on the circumstances). If the debt were treated as a fund obligation, the debt might be considered “acquisition indebtedness” under the broad construct of the UBTI rules and tax-exempt investors in the fund could become subject to tax on income generated from the portfolio company investment. (Back to the Top)
A: From the lender’s perspective, if a debt restructuring results in a taxable exchange, the lender realizes gain or loss. The installment sale rules may apply if gain is realized. If the restructuring is treated as a tax-free recapitalization, gain is generally deferred, subject to certain limitations (e.g., to the extent cash is received). In the context of a corporate debtor, the determination of whether an exchange (or deemed exchange) of an original debt instrument for a new debt instrument turns on whether the debt instruments at issue constitute securities for tax purposes (generally, debt instruments with at least a five-year term). (Back to the Top)
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.