Late Friday evening, the Small Business Administration (SBA) issued an Interim Final Rule on affiliation, which was posted to the U.S. Treasury Department’s Paycheck Protection Program (PPP) loan website. This interim final rule (SBA Interim Final Rule 2) supplements an earlier SBA Interim Final Rule (SBA-2020-0015), which specifically did not address affiliation. The new PPP affiliation rules in SBA Interim Final Rule 2 clarify which SBA affiliation rules apply to the PPP.
Another document posted on the Treasury website, labeled “Affiliation Rules Overview”, offers additional statements about the affiliation considerations that apply to the PPP program.[1]
Taken together, these clarifications may result in expanded eligibility for small businesses with significant private equity or venture capital investment, which otherwise might not have qualified for a PPP loan.
In particular, the SBA Interim Final Rule 2 make the following clarifications for potential PPP loan applicants:
- Unless the applicant is a business with a NAICS code of 72, a business concern operating as a franchise, or a business that has received financial assistance from a Small Business Investment Company (SBIC), the affiliation rules in 13 C.F.R. 121.301[2] will apply, subject to the limitations below.[3] These affiliation rules, applicable to other existing SBA loan programs, establish that entities may be considered affiliates based on factors including stock ownership, overlapping management, and identity of interests.
- The affiliation rules do not apply to faith-based organizations that would otherwise be qualified for PPP loans, but for affiliation. “[T]he SBA’s affiliation rules, including those set forth in 13 CFR part 121, do not apply to the relationship of any church, convention or association of churches, or other faith-based organization or entity to any other person, group, organization, or entity that is based on a sincere religious teaching or belief or otherwise constitutes a part of the exercise of religion.”
Further, the Affiliation Rules Overview highlights the following affiliation principles from 13 C.F.R.121.301. Each of these situations would be deemed to create affiliation:
- Affiliation Based on Ownership
- A concern is an affiliate of an individual, concern, or entity that owns or has the power to control more than 50% of the concern’s voting equity
- If no individual, concern, or entity is found to control, 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 concern.
- 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.
This latter test in particular is less strict than the tests for affiliation involving minority control under 13 C.F.R. 121.103(c) and will expand eligibility for small businesses with significant minority investment, as long as those shareholders do not have significant negative control over the board or shareholders’ actions. Specifically, under 13 C.F.R. 121.103(c), for a business that had no majority owner, SBA would determine the next largest owner(s) to have control, and only if the ownership of the concern is widely held and no ownership interest is a large single block of stock as compared to any other would SBA deem the Board of Directors and President or Chief Executive Officer to control the business concern. Under 13 C.F.R.121.301, which now applies, this additional analysis for minority shareholders is not required. Instead, the analysis will turn to negative controls blocking board or shareholder action, not minority holdings. In this context, SBA has held that a minority shareholder’s ability to obstruct the ordinary actions fundamental to daily operations will support a finding of negative control. However, a minority shareholder’s ability to protect its interests by blocking extraordinary actions would not result in a finding of negative control. See Size Appeal of Team Waste Gulf Coast, LLC, SBA No. SIZ- 5864, at 6-7 (2017) (citing Size Appeal of Eagle Pharmaceuticals, Inc., SBA No. SIZ-5023, at 10 (2009) and Size Appeal of Novalar Pharmaceuticals, Inc., SBA No. SIZ-4977, at 14 (2008) as examples of negative control).
- Affiliation arising under stock options, convertible securities, and agreements to merge
- Stock options, convertible securities, and agreements to merge[4] are considered to have a present effect on the power to control a concern. SBA treats such options, convertible securities, and agreements as though the rights granted have been exercised.
- Options, convertible securities, and agreements that are subject to conditions precedent that are incapable of fulfillment, 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.
- 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 will 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.
- Where the CEO or President of the applicant (or other officers or managers with control) also controls the management of one or more other concerns, those jointly managed concerns are affiliates.
- Affiliation also arises where 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.
- Affiliation also arises where a single individual, concern, or entity controls the management of the applicant concern through a management agreement.
- Affiliation based on identity of interest.
- A rebuttable presumption of affiliation arises when there is an identity of interest between businesses of close relatives (defined to include a spouse, parent, 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 industry in the same geographic area).
Finally, under Interim Final Rule 2, Faith Based Organizations are exempt from affiliation.
Other points concerning eligibility:
In other recent clarifications, SBA has explained that businesses that qualify under their applicable revenue size standard (and not just employee standards), as well as those with current SBIC investment, qualify for the program.
SBA also appears to indicate that the size standards for PPP are based on the number of domestic employees (“employees whose principal place of residence is in the United States”), which is different than the all-employee test that would be applied under other programs. This may help some concerns with significant overseas workforces, although it is clear loan proceeds can only be used to pay U.S. based workers.
In its initial Interim Final Rule, SBA also included other provisions generally applicable to its loan programs and applied them to PPP. Specifically, the SBA Interim Final Rule referenced the exclusions in 13 CFR 120.110 as further described under SOP 50 10. Under those regulations and that SOP, the following types of businesses are not eligible for PPP loans:
- Financial businesses primarily engaged in the business of lending, such as banks, finance companies, and factors (pawn shops, although engaged in lending, may qualify in some circumstances);
- Passive businesses owned by developers and landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds (except Eligible Passive Companies under § 120.111);
- Life insurance companies;
- Businesses located in a foreign country (businesses in the United States owned by aliens may qualify);
- Pyramid sale distribution plans;
- Businesses deriving more than one-third of gross annual revenue from legal gambling activities;
- Businesses engaged in any illegal activity;
- Private clubs and businesses that limit the number of memberships for reasons other than capacity;
- Government-owned entities (except for businesses owned or controlled by a Native American tribe);
- Businesses principally engaged in teaching, instructing, counseling, or indoctrinating religion or religious beliefs, whether in a religious or secular setting;
- Loan packagers earning more than one-third of their gross annual revenue from packaging SBA loans;
- Businesses with an Associate who is incarcerated, on probation, on parole, or has been indicted for a felony or a crime of moral turpitude;
- Businesses in which the Lender or CDC, or any of its Associates, owns an equity interest;
- Businesses which:
- Present live performances of a prurient sexual nature; or
- Derive directly or indirectly more than de minimis gross revenue through the sale of products or services, or the presentation of any depictions or displays, of a prurient sexual nature;
- Unless waived by SBA for good cause, businesses that have previously defaulted on a Federal loan or Federally assisted financing, resulting in the Federal government or any of its agencies or Departments sustaining a loss in any of its programs, and businesses owned or controlled by an applicant or any of its Associates that previously owned, operated, or controlled a business that defaulted on a Federal loan (or guaranteed a loan that was defaulted) and caused the Federal government or any of its agencies or Departments to sustain a loss in any of its programs. For purposes of this section, a compromise agreement shall also be considered a loss;
- Businesses primarily engaged in political or lobbying activities; and
- Speculative businesses (such as oil wildcatting).
The application form for the loan program asks the Applicant to certify that neither it, nor any entity with more than a 20% interest, is one of the sorts of businesses described above.
[1] Notably, this “overview” is not an amendment to the SBA affiliation regulations but merely a summary of the applicable regulations.
[2] The CARES Act itself referenced the affiliation regulations in 13 C.F.R. 121.103 (pertaining primarily to SBA contract eligibility), not those in 121.301; it seems as though this was an administrative error that has been corrected by the SBA. See SBA Interim Final Rule 2 at 6 (“However, the detailed affiliation standards contained in section 121.103 currently do not apply to PPP borrowers, because section 121.103(a)(8) provides that applicants in SBA’s Business Loan Programs (which include the PPP) are subject to the affiliation rule contained in 13 CFR 121.301.”)
[3] The affiliation rules regarding newly organized concerns, the totality of the circumstances, and based on franchise agreements are not included in the SBA Interim Final Rule 2 or the Affiliation Rules Overview.
[4] Agreements in principle to merge are given present effect, but agreements to open or continue negotiations at some future time are not.