By Michael Gershberg, Steven Steinman and Gail Weinstein

Law360 (April 29, 2020, 5:22 PM EDT )

Michael Gershberg

Steven Steinman

Gail Weinstein

The federal Coronavirus Aid, Relief and Economic Security, or CARES, Act, which was signed into law on March 27, provides funds for Small Business Administration Paycheck Protection Program loans. Interim final regulations were issued April 2, and additional interim final regulations, which relate to the SBA's affiliation rules, were issued April 3.

The principal and interest on the loan will be forgiven if the proceeds are used only for the permitted purposes, which primarily are payroll costs, during the covered time period and if employee levels and compensation are maintained.

Generally, the loans are available to any business concern that was in operation on Feb. 15, and has not more than a certain number of employees — in most cases, 500 employees whose principal place of residence is in the U.S.. Importantly, employees of the company's affiliates are also counted.

Affiliation Rules

The April 3 interim regulations clarify which affiliation rules are applicable to the PPP loans. Under the rules, affiliation is defined broadly, based on control or the power to control — whether affirmative or negative control — and including companies under common control.

In most cases, portfolio companies of private equity firms would not be eligible for PPP loans due to the affiliation rules because typically a private equity sponsor, even if a minority shareholder, controls its portfolio companies.

Under the affiliation rules, a sponsor may be deemed to have control based on:

• Ownership of a majority of the voting stock;
  
  
• Ownership of a minority of the voting stock if the sponsor has consent rights over ordinary business decisions or the ability to block a quorum;
  
  
• Overlapping boards or management among portfolio companies;
  
  
• An identity of interest based on substantially identical business or economic interests, such as common investments or "economic dependence" through contractual or other relationships; or
  
  
• The totality of the circumstances.

We note that in many cases venture capital-backed companies may be eligible for PPP loans because these investments often do not include control rights.

Exclusion From the Affiliation Rules

Under the CARES Act and the related regulations, aggregation with affiliates is waived for faith-based organizations; and is waived for businesses that (1) are in the hotel or food services industries and do not employ more than 500 employees per physical location; (2) are franchises listed in the SBA's franchise directory; or (3) receive financial assistance from small business investment companies, or SBICs, licensed by the SBA.

Note that a private equity-sponsored portfolio company that is not otherwise eligible for a PPP loan due to the affiliation rules may qualify for and obtain a loan under the SBA's SBIC program and thus become eligible for a PPP loan through this exemption from the affiliation rules. However, SBIC loans are restricted to very small companies, based on assets and revenues, and the application process is onerous.

More Than One Entity May Control

Note that, based on decisions issued by the SBA Office of Hearings and Appeals, or OHA, which hears appeals of the SBA's size test determinations, more than one person or entity may be deemed to be in control of a company under the affiliation rules.

Thus, for example, if a company has three equal minority shareholders, and unanimous consent of the three is required for all decisions, the three shareholders and the company — and all other companies controlled by any of the three shareholders or the company — would be affiliates, even though none of the three shareholders has the ability to direct what the company does.

Bases for Affiliation

For PPP loan purposes, affiliation may be based on several factors.

Majority Ownership

If an entity — or, in each case where referenced, a person — owns or has the power to control more than 50% of a company's voting stock or membership interests, the entity and the company are affiliates. If there is no such more-than-50% owner, then the board of directors, the CEO, or other officers, managing members, or partners who control the management of the company are deemed to control the company.

Note that stock options and convertible securities are treated as if already exercised and a pending merger agreement, including an agreement in principle, is treated as already having been effected — based on OHA decisions, unless the likelihood of exercise of the rights or consummation of the transaction is shown to be extremely remote.

Minority Ownership

Importantly, a minority shareholder will be deemed to control the company if it has the ability under the company's charter, bylaws or a shareholders agreement "to prevent a quorum or otherwise block action by the board of directors or shareholders."

The regulations do not indicate whether a right to block any action, or only a right to block certain kinds of actions, would be sufficient for a finding of control.

However, decisions issued by the OHA indicate that minority holder consent rights that can block ordinary business decisions or ordinary actions essential to operating the company are sufficient to indicate affiliation; while consent rights that are designed only to protect the minority holder's interest, or that can block only extraordinary actions, are not sufficient to indicate affiliation.

Consent Rights Where OHA Deemed There Was Control

The following consent rights have been present in cases in which the OHA deemed there to be control:

• Forming a quorum of shareholders;
• Payment of dividends or distributions;
• Determining employee compensation;
• Ability to hire and fire executives;
• Establishing or amending an incentive or employee stock ownership plan;
• Broad power to block any changes in the company's strategic direction;
• Committing any act that would alienate or encumber assets;
• Amending or terminating lease agreements; purchasing equipment;
• Incurring debts or obligations;
• Adopting a budget or making changes to it; and
• Instituting or defending legal actions.
  
  

Consent Rights Where OHA Deemed There Was No Control

The following consent rights have been deemed by OHA not to constitute control:

• Rights designed only to protect the shareholder's minority interest;
  
• Mergers or sale of all or substantially all of the assets;
  
• Mortgaging or encumbering all or substantially all of the assets;
  
• Changing the amount of character of contributions to capital;
  
• Issuing additional equity;
  
• Increasing or decreasing the amount, or reclassifying, the authorized stock or interests;
  
• Adding new members;
  
• Changing the character of the business;
  
• Entering into substantially different business lines;
  
• Dissolving the company;
  
• Filing for bankruptcy;
  
• Amending the charter, bylaws, operating agreement or similar governing documents;
  
• Disposing of the good will;
  
• Submitting a claim to arbitration;
  
• Entering into a confession of judgment; or
  
• Acts required for the company to carry on its ordinary course of business.

Possibility of Restructuring to Avoid Aggregation

While generally a private equity sponsor would not want to give up control of its portfolio companies to gain eligibility for PPP loans, there may be certain circumstances under which, with respect to one or more portfolio companies, the need may be sufficiently high and/or the impact of a relinquishment of control sufficiently low to justify a restructuring of the investment.

For example, consent rights could be scaled back to cover only extraordinary actions, and no ordinary business decisions, or could be transformed into consultation rights only.

While the lender's or SBA's reaction to such a restructuring in the current environment is uncertain, at least one FAQ guidance issued by the SBA states that an irrevocable waiver or relinquishment of control rights would result in eligibility under the affiliation rules, absent applicability of another basis for affiliation.

It is unclear whether "irrevocability" could apply only to the period that the loan is outstanding.

Management

If the CEO or other officers, managing members, or partners who control management of the company also control management of another company, the companies are affiliates.

Also, if a single entity that controls the board or management of a company also controls the board or management of another company, the companies are affiliates.

The following examples are provided in the SBA regulations:

• Controlling members of A's board have three of five seats on B's board. Controlling members of A's board also control B's board — therefore, A and B are affiliates, and all companies controlled by A will be affiliates of B, and vice versa.
  
  
• A controlling member of A's board has veto rights over the decisions of B's board. Through the negative control right, A has control over B's board — therefore, A and B are affiliates, and all companies controlled by A will be considered affiliates of B, and vice versa.

In addition, an entity that controls the management of a company through a management agreement is an affiliate.

Identity of Interest

General

Entities may be affiliated if they have an identity of interest, meaning "identical or substantially identical business or economic interests," such as "close relatives, individuals or firms with common investments, or firms that are economically dependent through contractual or other relationships."

The determination on this basis can be rebutted by "evidence showing that the interests deemed to be one are in fact separate."

Close Relatives

Affiliation arises when there is an identity of interest between close relatives — specifically, 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 they operate concerns in the same or similar industry in the same geographic area.

Common Investments

Affiliation arises through common investments where the same individuals or firms together own a substantial portion of multiple concerns in the same or related industry, and such concerns conduct business with each other, or share resources, equipment, locations, or employees with one another, or provide loan guaranties or other financial or managerial support to each other.

However, where an SBA lender has made a determination of no affiliation under this ground, SBA will not overturn that determination as long as it was reasonable when made given the information available to the SBA lender at the time. 

Economic Dependence

Affiliation based on economic dependence may arise when a company derived more than 85% of its receipts over the previous three fiscal years from a contractual relationship with another entity — unless the contracts do not restrict the company from selling the same type of products or services to another purchaser or the SBA agrees that the contracts do not provide the purchaser with control or the power to control the seller.

Newly Organized Concern

A newly organized concern is one that has been actively operating for two years or less. Affiliation may arise where current or former officers, directors, owners of a 20% or more interest, managing members or persons hired to manage day-to-day operations of one company organize a new company in the same or related industry or field of operation, and serve in those capacities at the new company, and there are "direct monetary benefits flowing from" the new company to the original company.

A company may rebut a determination of affiliation on this ground "by demonstrating a clear line of fracture between the two concerns." However, where an SBA lender has made a determination of no affiliation under this ground, the SBA will not overturn that determination as long as it was reasonable when made given the information available to the SBA lender at the time.

Totality of the Circumstances

In determining whether affiliation exists, "all connections between the company and a possible affiliate can be considered." Even though no single factor is sufficient to constitute affiliation, affiliation may be found "where there is clear and convincing evidence based on the totality of the circumstances."

Uncertainty Regarding Application of the Eligibility Rules

With respect to continued ambiguities in the rules, and to the extent that discretion has been accorded to the SBA lenders, it is unknown how the affiliation rules will be applied, particularly in cases where they are complicated or require nuanced judgments.

It is uncertain whether the lenders will be more liberal in finding eligibility — given their relative inexperience in making these determinations, as well as the intention that they ensure a rapid turnaround on making the loans available — or whether they will be more conservative, and simply not want to entertain any applications that present complicated issues.

It is also uncertain whether the lenders will be consistent among one another and the extent to which a bank with a preestablished relationship with the applicant may be more favorably inclined to find eligibility than would otherwise be the case.

Finally, it is uncertain how the regulations will be interpreted in the context of the highly unusual current environment related to the coronavirus pandemic.

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Michael T. Gershberg and Steven J. Steinman are partners, and Gail Weinstein is senior counsel at Fried Frank Harris Shriver & Jacobson LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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