SBA Affiliation Regulations Impacting Eligibility for Paycheck Protection Program 7(a) Loans
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) created a new program within the U.S. Small Business Administration’s (SBA’s) flagship 7(a) Loan Program called the “Paycheck Protection Program” (PPP). Under the PPP, SBA will guarantee 100 percent of the amounts loaned by participating lenders to certain U.S. small businesses, nonprofit organizations, veterans organizations and tribal businesses. The legislation authorizes $349 billion for commitments for the PPP. Eligible participants are permitted to borrow up to $10 million under the PPP (covered loans) from February 15, 2020 through June 30, 2020 (covered period). For more information on the PPP, see our March 27 summary.
Eligibility
All “small business concerns” are eligible to receive a covered loan during the covered period. A business is a “small business concern” if:
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the size of the concern alone (without affiliates) does not exceed the size standard designated for the industry in which the applicant is primarily engaged,
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the size of the concern combined with its affiliates is not greater than the size standard designated for either the primary industry of the concern alone or the primary industry of the concern and its affiliates, whichever is greater.
SBA’s size standards make reference to the North American Industrial Classification System (NAICS) codes and are based on either the number of employees or receipts, depending on the industry.
The PPP extends eligibility to obtain a covered loan during the covered period beyond “small business concerns” to any business concern, nonprofit organization, veterans organization or tribal business concern if the business concern, nonprofit organization, veterans organization or tribal business concern has no more than 500 employees. Thus, if a business seeking a covered loan operates within an industry for which SBA has established a size standard based on receipts, then the business is eligible to receive a covered loan so long as it and its affiliates do not have more than 500 employees. In addition, if a business seeking a covered loan operates within an industry for which SBA has established a number of employees standard of more than 500, then the business is eligible to receive a covered loan if it and its affiliates have no more than the number of employees so established by SBA. It is important to consider the affiliation rules because employees of entities controlled by investors that possess certain rights described below would be counted when determining the number of employees of the business applying for a covered loan.
Under current SBA regulations, when counting the number of a business concern’s employees, the employees of the concern and its affiliates (domestic and foreign) are counted. 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. There are also other circumstances when affiliation may be found that are described in more detail below. The considerations are very fact-dependent. More information can be found in the SBA affiliation regulation as it pertains to SBA’s Business Loan Programs. 1
CARES Act Waiver of Applicability of Affiliation Regulations
The CARES Act states that the provisions applicable to affiliations apply with respect to a nonprofit organization and a veterans organization in the same manner as with respect to a small business concern. However, during the covered period, the provisions applicable to affiliations are waived with respect to eligibility for a covered loan for the following business concerns:
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any business concern with no more than 500 employees that, as of the date on which the covered loan is disbursed, is assigned a NAICS code beginning with 72 (Accommodation and Food Services)
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any business concern operating as a franchise that is assigned a franchise identifier code by SBA
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any business concern that receives financial assistance from a company licensed by SBA as a “small business investment company” (SBIC).
Unless one of the narrow waiver exceptions applies, SBA’s affiliation principles present challenges for the portfolio companies of private funds, particularly more mature funds and their related funds, in being able to access a covered loan because the structure of investments by private funds customarily includes provisions granting extensive rights as well as a majority control position. Thus, employees of all of the private fund’s portfolio companies that share such common control would be aggregated for the purpose of determining whether there are more than 500 employees.
Affiliation Based on Ownership
Generally
When determining affiliation for an applicant based on equity ownership:
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Any individual, concern or entity that owns or has the power to control more than 50 percent of the applicant’s voting equity is an affiliate of the applicant. Any concern or entity owned or for which the power to control by the individual, concern or entity in question is also an affiliate.
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If no individual, concern or entity is found to control, then SBA will deem the board of directors or president or chief executive officer (CEO) (or other officers, managing members or partners who control the management of the concern) to be in control of the applicant.
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In addition, SBA will deem a minority shareholder to be in control of the applicant if that minority shareholder has the ability, under the concern's charter, bylaws or shareholder's agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.
Principles Applicable to Minority Ownership – When Do Blocking Rights Constitute “Control?”
Before the June 2016 implementation of the Existing Governing Rule, SBA long held under the Prior Governing Rule that minority owners may have negative controls to protect their investment without creating affiliation (good veto rights) as long as the negative controls do not create control over day-to-day business operations (bad veto rights). SBA has not yet issued guidance on whether, and the extent to which, this precedent continues to apply to the Existing Governing Rule. In our view, it is appropriate to apply this precedent when evaluating minority blocking rights under the Existing Governing Rule because the Existing Governing Rule uses the same language with respect to minority blocking rights as existed under the Prior Governing Rule with no substantive change and SBA’s discussion in its release of the Existing Governing Rule did not state that this precedent no longer applies.
So what constitutes a good veto right as opposed to a bad veto right? SBA’s Office of Hearings and Appeals (OHA) previously issued determinations that provide guidance as to the delineation between good veto rights and bad veto rights.
Below is a table summarizing what OHA has concluded are good veto rights and bad veto rights.
Good Veto Rights |
Bad Veto Rights |
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The summary of veto rights in this table is not intended to be exhaustive, and there may be other veto rights that will need to be analyzed to determine whether they provide blocking rights with respect to day-to-day business operations.
It is important to note that the analysis as to whether a minority owner has a veto right focuses on the minority owner itself. Thus, if a minority owner alone has a blocking right, then the minority owner has control over the action or matter in question. However, a minority owner will not be deemed to have control over an action or matter merely because the owner is part of a class or group of owners that has blocking rights. If the minority owner is part of a class or group of owners that has blocking rights, the minority owner needs to ask the following question:
“Can the action or matter over which the class or group has a blocking right still occur if I vote ‘no’ or abstain from voting?”
If the answer to that question is “yes,” then the minority owner does not have control over the action or matter at issue. On the other hand, if the answer to the question is “no,” then the minority owner does have control over the action or matter at issue. These considerations hold true whether or not the minority investor has such controls in its capacity as an owner or whether the minority investor serves (or appoints a representative to serve) as a member of the board of directors or other governing body of a company.
The following example is illustrative of this analysis with respect to a hypothetical minority investor that is part of a class or group of owners that has blocking rights.
Facts
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I am a minority owner of a company and part of a class or group of owners that has a blocking right for the company to hire and fire executives (a bad veto right).
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The blocking right requires the approval of the owners constituting at least 75 percent in interest of the class or group.
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I control 26 percent of the interest in the class or group of owners having this blocking right.
Question to be Answered
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Can the company hire or fire an executive if I vote “no” or abstain from voting?
Answer to Question and Conclusion
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The company cannot hire or fire an executive if I vote “no” or abstain from voting because the 75 percent threshold cannot be reached due to the fact that I control 26 percent of the interest of the class or group having the blocking right over this matter.
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Therefore, I have control as to the company’s ability to hire and fire executives.
Given all of this, we recommend that minority owners of businesses that want the business to apply for a covered loan review the investment and governance documents relating to their investments to evaluate whether they have bad veto rights. If a minority owner has bad veto rights, then the company and the minority owners may want to consider amending the applicable documents to restructure the voting thresholds so that no single minority owner controls the determination of whether the action or matter in question can occur or to remove the bad veto right altogether.
In doing so, there may be ways for owners to protect against the occurrence of certain undesired actions or matters through operative provisions that do not implicate a bad veto right. For example, SBA has viewed the ability to block the payment of dividends or distributions as a bad veto right. It may be possible for owners to eliminate this bad veto right and still protect against undesired dividend payments (to a junior class of equity for example) by including provisions in the governing documents that prohibit dividends or distributions to any junior class of equity without the preferred dividend being paid to the senior class or without the participation by the senior class in the dividend or distribution to be paid to the junior class. As noted below, any elimination of, or modification to, bad veto rights will need to be in effect at the time the company applies for a covered loan under the PPP.
Affiliation Arising Under Stock Options, Convertible Securities and Agreements to Merge
In determining size, SBA also considers stock options, convertible securities and agreements to merge (including agreements in principle) to have a present effect on the power to control a concern, and treats these options, convertible securities and agreements as though the rights granted have been exercised. However, agreements to open or continue negotiations toward the possibility of a merger or a sale of stock at some later date are not considered ‘‘agreements in principle’’ and are thus not given present effect. In addition, options, convertible securities and agreements that are subject to conditions precedent; that are incapable of fulfillment; that are speculative, conjectural or unenforceable under state or federal law; or where the probability of the transaction (or exercise of the rights) occurring is shown to be extremely remote are not given present effect.
Importantly, an individual, concern or other entity that controls one or more other concerns cannot use options, convertible securities or agreements to appear to terminate such control before actually doing so. SBA does not give present effect to individuals’, concerns’ or other entities’ ability to divest all or part of their ownership interest in order to avoid a finding of affiliation.
Affiliation Based on Management
Affiliation based on management can arise where:
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the CEO or president of the applicant (or other officers, managing members or partners who control the management of the concern) also controls the management of one or more other concerns
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a single individual, concern or entity that controls the board of directors or management of one concern also controls the board of directors or management of one of more other concerns
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a single individual, concern or entity controls the management of the applicant concern through a management agreement.
Affiliation Based on Identity of Interests
Affiliation can arise when there is an identity of interest between close relatives (a spouse; a parent; or a child or sibling, or the spouse of any such person) with identical or substantially identical business or economic interests (such as where the close relatives operate concerns in the same or similar industries in the same geographic area). If 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.
Affiliation Based on Franchise Agreements
The restraints imposed on a franchisee or licensee by its franchise or license agreement generally will not be considered in determining whether the franchisor or licensor is affiliated with an applicant franchisee or licensee so long as the applicant franchisee or licensee has the right to profit from its efforts and bears the risk of loss commensurate with ownership. SBA only considers the franchise or license agreements of the applicant concern.
Conclusion
Many startup and emerging-growth companies, as well as many organizations that represent and support them, and are actively asking SBA to provide relief from its affiliation requirements for purposes of PPP-covered loans, given the importance of this emergency funding. While many of these startups have fewer than 500 employees, they will, as a result of SBA’s affiliation requirements, be ineligible to receive PPP funding as a result of having private investors such as venture capital, private equity and growth capital funds.
Many national and regional organizations, as well as the Institutional Limited Partners Association , have sent letters to Treasury Secretary Mnuchin and SBA Administrator Carranza in support of such relief. In addition, House Speaker Nancy Pelosi sent a letter to Treasury Secretary Mnuchin and SBA Administrator Carranza regarding application of the affiliation rule to the PPP, encouraging them to exercise appropriate discretion under the CARES Act with respect to SBA’s affiliation principles so as to secure coverage for as many small businesses having under 500 employees as possible.
However, unless and until SBA provides relief from its affiliation rules, any company having private investors (particularly venture capital, private equity and growth capital fund investors) that would like to apply for a covered loan should review its investment and governing documents to identify any blocking rights that those investors may have, categorize them into good veto rights and bad veto rights, and either eliminate or restructure the voting thresholds with respect to the bad veto rights. Any such elimination or restructuring of bad veto rights will need to be in effect at the time the company applies for a covered loan under the PPP.
Endnote
1 Before June 2016, SBA’s affiliation regulations for its Business Loan Programs, including the 7(a) Loan Program, were governed under 13 C.F.R 121.103 (Prior Governing Rule). In June 2016, SBA issued the regulations in 13 C.F.R 121.301(f) (Existing Governing Rule) to simplify, separate and distinguish the Business Loan Program affiliation rules from SBA’s government contracting and other programs (which are still governed by the Prior Governing Rule). We note that the link to the Existing Governing Rule included in this article is the version of the regulation as it existed before SBA’s adoption of the interim final rule titled “Express Loan Programs; Affiliation Standards,” 85 Fed. Reg. 7622 (Feb. 10, 2020), because the CARES Act permanently rescinded this February 2020 interim final rule, it no longer has any force and effect. Thus, the Existing Governing Rule as in effect before the adoption of the February 2020 interim final rule is what is relevant to the affiliation analysis for the PPP. The actual rules are on pages 6 and 7 of the document at the link. We encourage readers to review the document referenced in this article rather than other documents because these other documents may very well include the modifications made by the February 2020 interim final rule that do not apply.
Yueyang (Sophie) Zhang, an associate in the Corporate and Securities Practice Group, contributed to the research for this article.