Overview

In March 2020, as a result of economic upheaval caused by COVID-19, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act). Among other things, the CARES Act established the Paycheck Protection Program (PPP) through the Small Business Administration (SBA), which provides forgivable loans to eligible small businesses facing economic hardship to retain U.S. employees on their payroll during the COVID-19 pandemic.

In order for a potential borrower to have qualified for a PPP loan, the CARES Act required it to satisfy two main conditions: first, be considered a “small business;” and second, make certain specified certifications. Generally, a business qualified as a “small business” if it had (a) 500 or fewer employees whose principal place of residence is in the United States or was otherwise a “small business” under the applicable NAICS code employee size standards or (b) $15 million or less tangible net worth and an average net income after federal income taxes (excluding any carry-over losses) of not more than $5 million for the previous two full fiscal years. Eligible borrowers were required to make good faith certifications including that: (1) current economic uncertainty made the loan necessary in order to support the ongoing operations of the borrower; (2) the funds would be used to pay the payroll or make mortgage interest payments, lease payments and utility payments; (3) the borrower did not receive another loan under the PPP program; and (4) any other SBA loans received during a specified period in 2020 were obtained and used for purposes other than the allowable uses under the PPP. Our prior alerts on PPP loans can be found on our COVID-19 crisis response group website here.

As with all sectors of the economy, the COVID-19 pandemic has disrupted the market for M&A transactions. In light of this, potential buyers in M&A transactions must consider the changing risk landscape. This article discusses a particular new issue introduced by the COVID-19 pandemic: the potential impact of PPP loans on M&A transactions. Specifically, the article covers areas of concern throughout the diligence and negotiation process of an M&A transaction if the acquisition target is a PPP loan recipient.

Diligence Considerations

Given the additional uncertainty and risks that PPP loans introduce to a potential transaction, sellers should expect, and buyers should insist on, additional diligence requests specific to the PPP loan. The following are some of the diligence issues that buyers should consider when preparing a diligence request list and reviewing the responses and documents provided by the seller.

• Considerations in a Target’s taking of a PPP loan. Buyers will want to consider a target-borrower’s need for a PPP loan in evaluating the target’s operations, cash flow and working capital needs for the business post-acquisition and post-PPP loan repayment or forgiveness.
  
  
• Compliance with CARES Act and SBA Rules. As noted above, borrowers under the PPP were subject to certain eligibility requirements and affiliation rules and were required to make certain certifications at the time of their loan application (and their forgiveness application, if they have applied for forgiveness). A buyer must use the diligence process to assess the target’s compliance with the CARES Act and SBA requirements with respect to its PPP loan, including verifying the validity of the certifications made in its applications.
  
  The SBA has stated that PPP loans for $2 million or greater are subject to audits for a 6-year period.¹ In addition, the SBA reserved the ability to review PPP loans other than those in excess of $2 million “as appropriate.”² A target that received a PPP loan could be subject to criminal or civil penalties if it is determined that its loan application or necessity certification contained false or misleading information. It is important to note that regardless of the transaction structure, the parties should be vigilant in assessing PPP loans in the diligence process as the borrower can still be subject to liability even if the parties determine that the PPP loan will be repaid at closing. Given the potential for liability, the diligence process should include a review by the buyer of all documentation related to the target’s PPP loan application and PPP forgiveness application and any related documentation that the target used to provide support for the statements and certifications made as part of the application process.
  
  
  • Eligibility Determination. Buyers should analyze any existing documentation to confirm that the target was eligible to receive the PPP loan under the CARES Act and applicable SBA rules. For example, this documentation should confirm the borrower was not an ineligible business, include business records showing the employee count or net worth/net income of the borrower at the time of the application (depending on which metric the borrower relied on to qualify as eligible), as well as any electronic or other communications regarding the eligibility determination. Employee count is affected by the SBA’s affiliation rules which consider the borrower’s headcount together with its affiliates'. Under the SBA’s affiliation rules, 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. The SBA’s definition of “control” is expansive and includes, among other tests, voting control or contractual control, including a minority stockholder’s ability to block action by a borrower’s board of directors or stockholders. Buyers should review the target’s analysis of the applicability of the SBA’s affiliation rules and the tests for affiliation to determine whether the target-borrower met the employee count requirements for eligibility.
    
    Additionally, the PPP application requires that the borrower list the number of employees as of the application date. However, the loan amount is based on average monthly payroll for either calendar year 2019 or the trailing 12-month period at the borrower’s option. Accordingly, buyers should review which period the business used in calculating average monthly payroll and confirm that the relevant headcount did not exceed the threshold during the applicable period. Seasonal and new businesses were permitted to base average monthly payroll on shorter timeframes as specified in SBA guidance.
    
    
  • Calculation of Loan Amount. Buyers should also analyze existing documentation, including financial and payroll records, to confirm that the target accurately calculated its PPP loan (including number of employees and payroll amount) and that the full PPP loan will be eligible for forgiveness if other conditions under the PPP are met.
    
    
  • Necessity Certification. Further, the buyer should confirm that the target has a record of the information or documents supporting its PPP eligibility determination should there ever be an audit of the loan. The buyer should review documentation of the target’s board of directors’ assessment, determination and approval of the PPP loan. The buyer should also diligence the target’s certification that the loan was necessary to support ongoing operations and relevant supporting documentation. Target-borrowers should have engaged their advisors, management and boards of directors in determining whether to apply for the PPP loan, including making a good faith determination of necessity. Considerations can include, among others, cash and operational needs, a going concern analysis, cash runway, forecasts, budget and business plan, and the economic need for the loan and its impact to the business and its operations.
    
    
    • Target-borrowers with PPP loans less than $2 million are subject to a safe harbor that deems them to have made the required certification of necessity in good faith, as the SBA presumes them to be generally less likely to have had access to adequate sources of liquidity than larger borrowers, though such borrowers still should have documentation assessing their financial condition, eligibility for the loan and determination in making the required certifications.
      
      
    • Target-borrowers with PPP loans of $2 million or greater should have assessed whether alternative means of financing were available. This assessment should be accompanied with documentation supporting its good faith determination of necessity and that it considered other sources of liquidity in providing the necessity certification. While having other sources of funding is a factor and could cut against a borrower’s “necessity” certification, that is not always the case and boards retain discretion in evaluating necessity in accordance with their business judgment.
      
      
  • Impact of Sale on PPP Use of Proceeds Requirements. In asset sales, carve-out transactions and divestitures, where the PPP loan is a liability retained by the seller, the seller will need to consider whether it can continue using the PPP loan proceeds for the permitted purposes (e.g. spending at least 60% of the PPP loan funds on payroll), after selling all or a significant part of its operations. A buyer’s analysis of the to-be-acquired subsidiary’s post-closing working capital requirements, when evaluating its ability to operate with the buyer and without the selling parent-borrower, should include any reliance the target had on funds from the selling parent’s PPP loan.
    
    
  • Use of PPP Loan Funds; Forgiveness. Buyers will also want to review any documents supporting an existing or potential application for loan forgiveness (including verifying the validity of the certifications provided in the application) if the loan will not be repaid at closing. For example, the buyer should review any records showing how the PPP loan money has been spent in order to determine if (a) it has been spent during the applicable covered period, (b) it has been spent on permissible uses within the required 60/40 threshold of payroll to non-payroll costs, and (c) there has been any reduction to the employee levels or compensation beyond allowable thresholds during the loan forgiveness period that are not eligible for forgiveness exemptions or safe harbors (such as the forgiveness exemption for borrowers who reduced full-time equivalent employees if the borrower was unable to rehire or return to the same level of business activity as before the COVID-19 crisis and safe harbors for restoring such levels by December 31, 2020), as those could decrease the amount eligible for forgiveness.
    
    
• Required Consents. Depending on how the transaction is structured, PPP loans may require lender and/or SBA approval of the transaction. In order to determine whether any such consents are required, buyers should diligence the PPP loan documents including the underlying promissory note as well as the SBA’s guidelines.
  
  It is typical for PPP loan documents to require lender consent in the event of a change of control, change of ownership, change in the nature of the business, assignment of the loan, or an asset sale³ outside the ordinary course of business during the term of the loan. If a borrower enters into a transaction without lender consent in violation of the loan documents, the loan could lose its eligibility for forgiveness among any other remedies available to the lender.
  
  While not all lenders have used the SBA standard form of note, most follow the provisions and certifications contained in the SBA form. The form of SBA promissory note provides that the borrower will be in default if it “[r]eorganizes, merges, consolidates or otherwise changes ownership or business structure without Lender’s prior written consent,”⁴ and such a default triggers various rights of the lender, including the right to require immediate repayment of the loan.⁵ In addition, if the PPP loan was included in the asset sale and the buyer wanted to assume the loan and release the seller, prior SBA consent would likely be needed as part of the lender’s process for issuing its approval. If the parties decide that the PPP loan should remain outstanding post-closing, both buyers and sellers need to take into account these requirements and time required to obtain these consents and build the process for obtaining consents into the deal process and timeline. Sellers will want to start the consent process with their lenders as early as possible to reduce the timing risks associated with obtaining consent as a condition to closing.
  
  Lender consent requirements must also be considered in situations where the target has applied for loan forgiveness but is waiting for approval. After a borrower submits an application for forgiveness to its lender, the lender has up to 60 days to review the borrower’s calculations and supporting documents and confirm the forgiveness amount before the application is submitted to the SBA. Then, once the SBA has received the application, it has up to 90 days to approve the application.⁶ This means that loan forgiveness may take up to 150 days or more following the forgiveness application. Notably, the SBA only recently opened its forgiveness portal and many lenders have not set up their forgiveness process yet as they are looking for more SBA guidance to make it easier for them to process. Several banks have publicly stated they would not launch their forgiveness process until late August or early September. As a result, many borrowers cannot apply for forgiveness at the time of the writing of this alert.
  
  If the parties decide to keep the PPP loan outstanding post-closing, buyers will also need to consider their existing debt and credit facilities to ensure they have the ability to assume the PPP loan and comply with the requirements and restrictions under their existing debt structure.
  
  Given these potentially long time periods before approval is received, the parties can agree to (a) repay the loan prior to closing, in which case no lender consent would be required; (b) delay closing until the forgiveness application is approved, in which case no lender consent would be required (assuming lender consent is triggered only upon a closing and not the execution of the transaction documents); or (c) keep the loan outstanding post-closing, in which case the parties should assume that the same consent requirements described above apply and should obtain lender consent prior to closing.
  
  
• Aggregation Considerations. Though the application period for new PPP loans is now closed, it is conceivable that Congress could elect to open a new PPP program, which remains a possibility as the most recent COVID-19 stimulus bill introduced in the Senate (although not in the House of Representatives) includes a PPP 2.0 program. If such a program is established in the future, parties will need to consider how SBA rules and guidance regarding affiliation could affect a transaction, such as whether the buyer and target would be aggregated for purposes of the PPP loan even prior to the consummation of a transaction.
  
  
• Certain Tax Considerations. Targets taking advantage of PPP loan forgiveness may owe more federal income tax than they expected, triggering several considerations for buyers in due diligence.
  
  While a forgiven loan generally triggers cancellation of debt income to a debtor, the CARES Act provides that the amount of the forgiven PPP loan is excluded from gross income. But the IRS has taken the position in Notice 2020-32 that otherwise deductible expenses paid using the proceeds of forgiven PPP loans are not deductible. The net effect of this position is to place borrowers in the same economic position as if the forgiven PPP loan were taxable.
  
  Buyers should thus confirm that targets have properly accounted for the IRS’s position to avoid possible penalties and interest for underpaid taxes. This effort may include reviewing targets’ estimated tax payment calculations and payments and copies of tax returns.
  
  Targets may be required to file an amended tax return once the actual amount of PPP loan forgiveness is finally determined. For example, if the target does not claim a deduction for an expense paid for with PPP loan proceeds (under the assumption that the PPP loan will be forgiven) and if the forgiven amount is ultimately different than estimated, the target may need to amend its return accordingly. Buyers may seek to review any such returns and should otherwise be aware of the need to file those such returns at the appropriate time.
  
  

Negotiating the Definitive Agreement

Following a thorough diligence process, the parties should consider the impact of PPP loans and any specific risks identified during the diligence phase when negotiating the definitive transaction agreement.

• Purchase Price Adjustments. Parties to a transaction may elect to keep a target-borrower’s PPP loan outstanding for any number of reasons. If so, and if the closing is weeks or months away and forgiveness is in sight, buyers might wish to categorize the PPP amount as indebtedness. This has the effect of reducing the purchase price at closing but if forgiveness is later obtained, the amount of PPP indebtedness can be appropriately adjusted based on the amount actually forgiven vs. not forgiven and the purchase price correspondingly adjusted. The result is that the PPP loan is treated as other indebtedness but the seller is compensated for the amount of the loan actually forgiven. Alternatively, the parties may agree to give the seller the benefit of the forgiveness amount (either the maximum calculated by the target-borrower or some discounted forgiveness amount to account for risk of receiving less-than-maximum forgiveness) with the post-closing adjustment applied to true-up the forgiveness amount to the extent the maximum amount of the loan is not actually forgiven. Timing around PPP forgiveness and the period of any post-closing adjustment needs to be considered by the parties, as they will need to determine whether to include PPP forgiveness in a post-closing adjustment and what the timeframes should be given the extended time periods that may be required to obtain PPP loan forgiveness as noted above. Parties may agree to place the maximum forgiveness amount of a PPP loan in a third-party escrow account subject to release to the seller upon forgiveness of the PPP loan, to the extent of the actual amount forgiven, with the amount not forgiven released to the buyer.
  
  
• Representations and Warranties. The parties can include PPP loan-specific representations and warranties in the definitive agreement to ensure that the diligence process is appropriately thorough on the buyer’s end and elicits all necessary disclosure from the target. While not intended to be a full substitute for proper diligence, the additional representations and warranties should help backstop any unforeseen liability post-closing. Additional representations and warranties from the target could include that: (i) the target received funds under the PPP, (ii) the target was eligible to apply for and receive a PPP loan, (iii) the calculation of the loan amount was accurate, (iv) at the time of its application for the PPP loan (and forgiveness, if applicable), all claims and certifications made by the target in connection with such application were true, correct and made in good faith, (v) that the PPP loan funds were used for permissible purposes and are eligible for full forgiveness and (vi) the target has been, and as of the date of the agreement is, in compliance with all requirements applicable to the PPP.
  
  Customary tax representations are typically broad enough to speak to issues discussed above relating to forgiveness of a PPP loan. But buyers may seek to add specific representations relating to a target’s compliance with the IRS’s position in Notice 2020-32, including that the target has accrued, paid, and reported all taxes consistent with the Notice, to backstop buyers’ diligence efforts.
  
  
• Representations and Warranties Insurance. The impact of COVID-19 and developments related to the pandemic on the availability and scope of representations and warranty insurance are constantly evolving and depend heavily on the insurer. An insurer will expect a buyer to have performed sufficient diligence on a PPP loan. However, if an insurer elects to exclude any representations and warranties specifically related to a PPP loan, a potential buyer should ensure that any breaches of those representations and warranties are backstopped by the seller, including through the use of a special indemnity as described below.
  
  
• Covenants. The parties should also consider including PPP loan-specific covenants. Some covenants would function to allocate risk between the parties. For example, if the transaction is structured so that the PPP loan is not repaid in connection with the closing, the target may also request certain covenants that would require the buyer to comply with the requirements of the PPP loan, apply for forgiveness and prohibit the buyer from acting in a way that would impact the ability to obtain forgiveness or decrease the forgiveness amount. If the transaction is not structured as a simultaneous sign-and-close, the buyer may request that the target covenant to do this in the event the target plans to apply for forgiveness prior to the closing.
  
  Other covenants would function to assign responsibility between the parties for certain actions. For example, the buyer should include a covenant giving it the right to control any future audits related to the PPP loan. In order to make such a covenant effective in the event of a future audit, the agreement should also require both parties to cooperate with any audits, investigations or litigation related to the PPP. Unlike audits, sellers may want to retain control of the forgiveness process, especially if the amount of forgiveness is tied to a post-closing purchase price adjustment as described above.
  
  
• Indemnification. Buyers should also consider structuring the indemnification framework to account for the target’s PPP loan and any potential issues identified in the diligence process. The buyer should evaluate what level of risk it believes the target’s PPP loan poses based on its diligence findings and draft the indemnification provisions accordingly. To minimize its risk associated with the target’s PPP loan, the buyer could ask that representations and warranties specific to the target’s PPP loan are treated as fundamental or quasi-fundamental representations, with a longer survival period and a higher (or no) cap and lower (or no) deductible on losses.
  
  If specific risks have been identified in diligence such as concerns around the target’s eligibility to receive a PPP loan, calculation of the PPP loan amount, compliance with the applicable requirements of its PPP loan or use of PPP loan proceeds that could jeopardize the potential for forgiveness, the buyer may want to request specific indemnification coverage for those issues.
  
  In the context of an asset sale, buyers should consider requiring that any liability associated with a PPP loan is a retained liability, with appropriately unlimited liability for claims related to retained liabilities. However, if a target-borrower is still in the coverage period and has not used all of the PPP proceeds prior to the closing of the sale, it may not be practicable to exclude a PPP loan from an asset sale and for such loan to remain outstanding with the target to the extent the target-borrower would be left without operations as a result of such transaction. In this case, the seller is unlikely to be able to meet the PPP loan use of proceeds requirements, including the requirement that funds be used for permitted purposes and at least 60% of PPP loan funds be used to cover payroll costs, as it may no longer have employees to pay. In certain asset sales, it may be feasible that a target-borrower retains the PPP loan during the coverage period, such as a sale of a subsidiary or division, or carve-out transaction not constituting a sale of substantially all assets, where the target-borrower remains a going concern.
  
  

Standalone Insurance for PPP Loans

A new insurance product is being offered to recipients of PPP loans that would provide coverage around the necessity certification made by the borrower in its application in the event that the SBA determines the loan was not actually necessary. However, it is important to understand that this insurance would not cover a situation in which the target was found in an audit to have otherwise been ineligible for the PPP loan, and that insurers will not offer coverage to borrowers they suspect have eligibility issues. It is also important to note that this insurance product is different from representations and warranties insurance that may be procured in connection with an M&A transaction, which is discussed above.

These PPP insurance policies could impact M&A transactions – while an insurer will likely not cover a company that is currently negotiating a potential transaction, it may consider insuring a company that is contemplating a sale process. Therefore, buyers should determine in diligence whether a potential target has obtained this kind of insurance prior to entering into negotiations with the buyer, understand the coverage and limitations, and determine whether it could be assumed by the buyer. Alternatively, a buyer could attempt to seek coverage post-closing.

Given that PPP insurance is a brand-new concept, there is significant uncertainty surrounding the availability and specifics of such insurance. Buyers should be diligent when dealing with a target who has obtained PPP insurance and, as this insurance product continues to evolve, in considering whether to obtain such a policy post-closing.

Conclusion

Parties to a potential M&A transaction should work closely with their counsel throughout the diligence process and negotiation of definitive agreements to evaluate the particular facts and circumstances surrounding a PPP loan and navigate the potential implications of a PPP loan on the transaction.

 

¹SBA Frequently Asked Questions (FAQs), Question 39, published April 29, 2020.

²Id.

³While there is no express prohibition or consent requirement in the SBA’s form of 7(a) loan note for sales of assets, the broad scope of the events of default could be construed to include asset sales, and buyers should evaluate whether lender consent is required in connection with a potential asset sale.

⁴SBA Form 147 (06/03/02) Version 4.1 at § 4(L).

⁵Id. at § 5(A).

⁶Interim Final Rule - SBA Loan Review Procedures and Related Borrower and Lender Responsibilities.

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