Borrower Beware Series - Part III: CARES Act Loan Certification Obligations Create Pitfalls for the Unwary

For additional guidance, please refer to Steptoe's COVID-19 Resource Center.

As highlighted in an earlier update in this "borrower beware" series, Congress and the president recently enacted the "Coronavirus Aid, Relief, and Economic Security Act" (the CARES Act), which provides an estimated $2 trillion in financial assistance to all corners of the economy. On April 9, the Federal Reserve announced a new Main Street lending program, along with term sheets and program requirements, as an added source of funding for American businesses (for more information on the Main Street lending program and Steptoe's analysis, click here). 

This installment of the "borrower beware" series focuses on the statutory requirements of—and potential pitfalls underlying—borrowers' loan certification obligations under the CARES Act. Although borrowers should examine the specific requirements of statutory program(s) applicable to them, this alert provides general guidance that businesses should consider before applying for financial assistance through the Act. 

Due to the sheer size of appropriations under the CARES Act, including the approximately $100 million earmarked for new oversight and enforcement activity, it is likely that sooner or later borrower disclosures and the use of loan, grant, or investment proceeds will be heavily scrutinized. Given this expected scrutiny, this installment of the "borrower beware" series discusses the disclosures and related obligations borrowers must undertake to obtain financial assistance under the CARES Act, its implementing regulations, and related guidelines. 

Borrower's Affirmative Obligations to Access Federal Support

Small Businesses 

Small businesses, as defined by the CARES Act and supplemented by interim rules, may apply for new loans through the Small Business Administration (SBA) programs funded by the CARES Act. 

Under the Paycheck Protection Program (PPP), small businesses can apply for loans of two-and-a-half times their average monthly payroll costs, or up to $10 million. PPP loans can be fully forgiven, provided that (1) the business maintains or rehires any employees by June 30, 2020 (the final date that PPP loans will be available); (2) the funds are used for payroll costs, mortgage interest payments, rent, and utilities; and (3) at least 75% of the forgiven amount must have been used for payroll. 

Eligible small businesses must calculate their average monthly payroll expenses, up to $100,000 on an annualized basis, or roughly $8,333 per month, for each employee. Payroll costs consist of compensation for employees whose principal place of residence is in the United States, in the form of salary, wages, commissions, or similar compensation; cash tips or the equivalent; payment for vacation, parental, family, medical, or sick leave; allowance for separation or dismissal; the provision of group health care benefits or retirement benefits; and state and local taxes on any such compensation. These expenses are normally calculated based on the average monthly payroll for 2019, although it can be based on different time periods for seasonal or newer businesses. 

Applicants must identify any owners of 20% or more of the equity of the business. For purposes of determining an entity's size (and hence eligibility for the program), applicants may be considered affiliated under SBA regulations based on a variety of considerations such as common ownership, management, or identity of interest, with stock options, convertible securities, and agreements to merge considered to have a present effect and treated as though they have been exercised. These affiliation requirements will be waived for franchises and for accommodation or food service businesses with 500 or fewer employees at any given physical location. 

Applicants must certify they are eligible for the program, including through additional guarantees that neither the applicant nor any of its owners have been barred from participation in the program, nor are they currently delinquent or have defaulted on a previous federal loan. Applicants must make a number of other specific certifications, including that: (1) current economic uncertainty makes the loan request necessary to support their ongoing business operations; (2) the funds will be used to retain workers and maintain payroll, or for mortgage interest payments, rent, or utilities; (3) that the applicant does not have a pending loan under the PPP, and has not and will not receive another loan under the PPP between February 15, 2020 and December 31, 2020; and (4) that all information provided in the application and any supporting documents are true and accurate in all material respects. Applicants will also be responsible for providing documentation to the lender verifying the number of employees and the dollar amounts of covered expenses for the eight-week period following the loan. 

Under the CARES Act, small businesses can also apply for loans through the existing Economic Injury Disaster Loan Program (EIDL), and can receive a $10,000 emergency grant in the form of a loan advance that will not have to be repaid. Businesses can borrow up to $2 million through EIDL, and the funds can be used for a wider array of operational costs, although the loan (with the exception of the $10,000 grant) will not be forgivable. Applicants must provide information including their gross revenues, cost of goods sold, number of employees, and any other reimbursement the applicant will receive, such as through insurance. 

Certain types of applicants are ineligible for EIDL loans, including those that are engaged in illegal activity; those that have a principal with a 50% or greater ownership interest that is more than 60 days delinquent on child support payments; and businesses that are an agricultural enterprise (with certain narrow exceptions), involve displays of a prurient sexual nature, derive more than one-third of their gross annual revenue from legal gambling activities, or are primarily in the business of lobbying or political activities. Applicants also must certify whether, among other things, the applicant or any listed owner has ever been convicted of a criminal offense committed during and in connection with a riot, civil disorder, or other declared disaster. 

Eligible Businesses for Loans, Loan Guarantees, or Investments from the Treasury Department or the Federal Reserve

In order for eligible businesses, states, and municipalities to participate in the CARES Act loan programs, they must make certain certifications in their applications. These certifications vary slightly depending on how the Act categorizes certain types of businesses. 

Direct Loans for Eligible Borrowers: In order for a borrower to receive a direct loan, it must certify the following: (1) it is domiciled in the United States (i.e., it was created or organized in the United States, or under the laws of the United States); (2) it has significant operations in the United States; and (3) a majority of its employees are based in the United States. 

A direct loan borrower must certify that it will comply with the following obligations that run through, and past, the duration of the loan: (1) it will not repurchase an equity security of the company or its parent while the direct loan is outstanding and 12 months thereafter; (2) it will not pay dividends with respect to its common stock while the direct loan is outstanding and 12 months thereafter; (3) employees who made more than $425,000 in 2019 cannot receive a raise, nor can severance be more than double maximum compensation; (4) executives who made more than $3 million in 2019 cannot make more than $3 million plus half of the amount over $3 million in 2020; and (5) it will only invest in, or loan to, American businesses. 

Mid-Sized Businesses: In order for a mid-sized business (generally 500 – 10,000 employees) to participate in the program, it must certify the following: (1) it is domiciled in the United States (i.e., it was created or organized in the United States, or under the laws of the United States); (2) it has significant operations in the United States; (3) a majority of its employees are based in the United States; (4); it has not otherwise received adequate economic relief in the form of loans or loan guarantees provided under the Act; (5) it is not a debtor in a bankruptcy proceeding; and (6) the loan is necessary to support ongoing business operations. 

Conditions of the loan require that a borrower do the following: (1) retain at least 90% of its workforce at full compensation and benefits until September 30, 2020; and (2) restore not less than 90% of its pre-February 1, 2020, workforce with full compensation and benefits no later than four months after the termination date of the public health emergency. 

Additionally, a borrower must certify that it will comply with the following obligations that run through, and past, the duration of the loan: (1) it will not pay dividends with respect to its common stock or repurchase an equity security of the company or its parent while the direct loan is outstanding; (2) it will not outsource or offshore jobs for the term of the loan and two years after completing repayment of the loan; (3) it will not abrogate existing collective bargaining agreements for the term of the loan and two years after completing repayment; (4) it will remain neutral in any union organizing effort for the term of the loan; (5) employees who made more than $425,000 in 2019 cannot receive a raise, nor can severance be more than double maximum compensation; and (6) executives who made more than $3 million in 2019 cannot make more than $3 million plus half of the amount over $3 million in 2020. 

Air Carriers, Cargo Carriers, and Businesses Critical to Maintaining National Security: In order for an air carrier, cargo carrier, or other business critical to maintaining national security to participate in the program, it must certify the following: (1) it is domiciled in the United States (i.e., it was created or organized in the United States, or under the laws of the United States); (2) it has significant operations in the United States; (3) a majority of its employees are based in the United States; (4); credit is not reasonably available to the business at the time of application; (5) the intended obligation by the applicant is prudently incurred; and (6) it has incurred or is expected to incur covered losses such that the continued operations of the business is jeopardized. 

Conditions of the loan require that a borrower do the following: (1) retain at least 90% of its workforce as of March 24, 2020, at full compensation and benefits to the extent practicable until September 30, 2020; and (2) not reduce its employment levels by more than 10% from the levels as of March 24, 2020, through September 30, 2020. 

Additionally, a borrower must certify that it will comply with the following obligations that run through, and past, the duration of the loan: (1) it will refrain from conducting involuntary furloughs or reducing pay rates and benefits until September 30, 2020; (2) neither the air carrier, contractor, nor affiliate may purchase an equity security of the air carrier, contractor, or parent company through September 30, 2021; (3) it will refrain from paying dividends or making other capital distribution with respect to its common stock; (4) employees who made more than $425,000 in 2019 cannot receive a raise, nor can severance be more than double maximum compensation; and (5) executives who made more than $3 million in 2019 cannot make more than $3 million plus half of the amount over $3 million in 2020; (6) borrowers must provide the Treasury secretary with a warrant or equity interest in the business or, alternatively, a senior debt instrument issued by the borrower; and (7) maintain certain scheduled air transportation (for more information, see Coronavirus Resources at the Department of Transportation). 

Conclusion 

The government's economic stimulus programs provide a robust source of funds for a broad swath of American businesses – a welcome life raft in these turbulent days. But participation in these programs carries significant risk. These programs require participating companies to demonstrate in sworn submissions that they are qualified to receive the programs’ benefits. Additionally, there will be significant reporting requirements for all participants, particularly those that will eventually seek debt forgiveness under the PPP. In these respects, and many others, program participants need to exercise great care to make sure their submissions are accurate. The unwary may unwittingly expose themselves to criminal prosecution and very substantial civil liability, which we will be discussing in greater detail in our next alerts. Close and timely consultation with in-house and external counsel, who are familiar with the obligations of program participants, is critical to each participant looking to reap the significant financial relief provided by these programs without taking on unnecessary and avoidable criminal and civil exposure.