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May 27, 2020

Considerations for Acquisitions and Investments Involving Companies That Have Taken CARES Act Funding

Coronavirus: Corporate and Finance Advisory

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The Coronavirus Aid, Relief, and Economic Security (CARES) Act established funding programs that have provided, and will continue to provide, critical economic support during the pandemic to entities throughout the United States. But the legislation was hastily drafted and imprecise in many respects. This Advisory describes some of the risks for acquirors of, and investors in, companies that have taken CARES Act funding.

Part I sets forth a brief summary of the various funding programs under the CARES Act to which this Advisory relates. A more extensive summary of these programs is included in a chart attached as Annex A. Part II describes various diligence issues that acquirors and investors should consider. Part III describes how the CARES Act funding programs will be enforced and risks to which acquirors and investors will be exposed. Part IV sets forth various implications for transactions involving investments in, and acquisitions of, companies that have received CARES Act funding.

I. Overview of Various Programs

A. EIDL and Emergency EIDL Grants

The Economic Injury Disaster Loan program (EIDL) is a pre-existing Small Business Administration (SBA) program that was expanded under the CARES Act. Under the expanded program, small businesses and most private, non-profit organizations may apply to the SBA for long-term working capital loans to help overcome the temporary loss of revenue caused by the COVID-19 pandemic.

Under the expanded program, EIDL loans are available to, among others, businesses with up to 500 employees (including part-time and seasonal employees but not independent contractors) and certain nonprofit organizations exempted under section 501(c), (d) or (e) of the Internal Revenue Code. EIDL loans are in an amount based on the economic injury suffered by the borrower, subject to certain exceptions up to a maximum of $2 million (which will be unsecured if under $25,000), carry interest at a rate of 3.75% for small businesses and 2.75% for non-profit organizations, and have a maximum term of up to 30 years. EIDL loans are working capital loans that can be used to pay fixed debts, payroll, accounts payable, and other bills that could have been paid had the disaster not occurred, but are not meant for business expansion. EIDL loans are not eligible for forgiveness.

Applicants submitting EIDL applications between January 31 and December 31, 2020 can also request an emergency grant in the amount of $1,000 per employee, up to a maximum of $10,000 (EIDL Grant). An EIDL Grant does not need to be repaid, even if the applicant's EIDL application is ultimately denied.


Like EIDL, the Paycheck Protection Program (PPP) is an expansion of an existing SBA program and is designed to help small businesses meet their payroll needs during the COVID-19 emergency. Under the PPP, SBA-approved lenders can make short-term loans with favorable terms to qualifying small businesses. The loans are fully guaranteed by the federal government.

Eligible borrowers include small business concerns under pre-existing SBA rules, most small businesses with up to 500 employees (including part-time and seasonal employees but not independent contractors), nonprofit organizations that are tax-exempt under Section 501(c)(3) and 501(a) of the Internal Revenue Code, and businesses with a NAICS code beginning with 72 (accommodation and food service industry) that have no more than 500 employees per physical location. PPP loans may be granted in amounts up to 2.5 times the applicant's average monthly payroll costs in 2019 (subject to certain exceptions), subject to a $10 million maximum, carry interest at a rate of 1% per annum and have a two-year term to the extent not forgiven. PPP loans can only be used for limited purposes, including payroll costs, mortgage interest payments, rent, utilities and interest on debt obligations incurred before February 15, 2020.

Unlike EIDL loans, the principal amount of PPP loans may be forgiven, in whole or in part, subject to limitations. Borrowers must apply to their lenders for forgiveness. Only amounts used for certain of the limited purposes set forth above may be forgiven, and at least 75% of the loan forgiveness amount must have been used to pay payroll costs. The amount for forgiveness is subject to reduction if the borrower has laid off or reduced the salaries or wages of its employees during the 8-week period following disbursement of the PPP loan. The amount eligible for forgiveness will also be reduced by the amount of any EIDL Grant received by the borrower.1

C. Main Street Lending Program

The Main Street Lending Program was established by the Federal Reserve under Section 13(3) of the Federal Reserve Act to support lending to small and medium-sized businesses that were financially sound prior to the COVID-19 pandemic. The Treasury Department committed to make an equity contribution to the Main Street Lending Program using funds allocated under Section 4003(b) of the CARES Act. The Main Street Lending Program consists of three facilities: (1) the Main Street New Loan Facility (MSNLF), (2) the Main Street Priority Loan Facility (MSPLF) and (3) the Main Street Expanded Loan Facility (MSELF).

Under each of the MSNLF, MSPLF and MSELF, which have many common features, eligible lenders can make new low-interest term loans, or in the case of the MSELF, upsize existing loans, to businesses with up to 15,000 employees or with 2019 annual revenues of $5 billion or less. Eligible lenders can sell 95% participations of eligible MSNLF and MSELF loans, and 85% participations of eligible MSPLF loans, to a special purpose vehicle established by the Federal Reserve Bank of Boston (which will be the lead Reserve Bank for the Main Street Lending Program). Loans issued under each of the three facilities have a four-year maturity, with principal and interest deferred for one year, have an interest rate of LIBOR plus 300 basis points, and are not eligible for forgiveness. The maximum amount of funding is tied to a multiple of borrower's 2019 adjusted EBITDA. The Main Street Lending Program is not yet operational as of the date of this Advisory.

D. Primary Market Corporate Credit Facility

The Primary Market Corporate Credit Facility (PMCCF) was established by the Federal Reserve under Section 13(3) of the Federal Reserve Act prior to passage of the CARES Act, with the Treasury Department subsequently committing to make an equity contribution using funds allocated under Section 4003(b)(4) of the Act. The PMCCF was established to provide a backstop for corporate debt to eligible investment grade issuers so they can maintain business capacity and operations during the period affected by the COVID-19 pandemic. The PMCCF will provide companies with access to credit by: (1) purchasing qualifying bonds as the sole investor in a bond issuance, or (2) purchasing portions of syndicated loans or bonds at issuance.

The PMCCF, together with the Secondary Market Corporate Credit Facility, will have a combined size of up to $750 billion. The Federal Reserve Bank of New York (which will be the lead Reserve Bank for the PMCCF) will operate both programs through a special purpose vehicle. The Federal Reserve Bank of New York allocated $50 billion of its initial $75 billion investment in this special purpose vehicle, to fund the PMCCF. The PMCCF is not yet operational as of the date of this Advisory.

II. Various Diligence Issues

This Part II addresses some of the key areas that may be suitable for acquiror or investor diligence in target companies that have obtained CARES Act funding.

A. Eligibility & Application Process

1. Did the company properly apply the SBA's affiliation rules in its application to obtain CARES Act funding?

Each of PPP, EIDL and the Main Street Lending Program requires that any applicable headcount-based and/or financial eligibility criteria be applied to the applicant and its affiliates, collectively. The SBA's rules for determining affiliate status are complex and differ from those applied under other regulatory schemes.2

Under the SBA's affiliation rules, an entity is considered to be an affiliate of a borrower if it controls, is controlled by or is under common control with the borrower. The SBA has issued a number of rules for determining whether "control" exists based on factors such as ownership, management, and identity of interest. Below are some of the more common relationships that can give rise to affiliate status:

  • An owner of over 50% of an entity's voting securities is considered to be in control of such entity. Options and securities convertible into voting equity are treated as having been exercised or converted unless they are subject to conditions that make their exercise speculative or the probability of exercise is shown to be extremely remote.
  • A minority shareholder is considered to be in control of an entity if the minority shareholder has the ability under the entity's organizational documents (including shareholder agreements) to prevent a quorum or otherwise block action by the board of directors or shareholders.
  • Minority shareholder consent rights can give rise to affiliate status, and are more likely to do so if they give veto rights over day-to-day business operations, as opposed to strategic transactions.
  • Merger agreements, including agreements in principle (though not agreements to open or continue negotiations), are treated as having created a control relationship unless subject to conditions that make their consummation speculative or the probability of the transaction occurring is shown to be remote. Accordingly, if a borrower enters into an acquisition agreement shortly after receiving funding for which the SBA affiliation rules apply, an argument could be made that the borrower had an oral understanding to be acquired at the time of the loan, and that the acquiror should therefore be treated as an affiliate of the borrower. This could call into question whether the borrower made accurate statements regarding its eligibility for the loan in its loan application.

Particular care should be exercised in evaluating borrowers with venture capital investors or that are private equity portfolio companies. They may be affiliates of the investor funds and all of their other investments.

2. Did the company properly calculate the number of employees it has for purposes of determining its eligibility to receive CARES Act funding?

PPP, EIDL and the Main Street Lending Program each have headcount-based eligibility criteria that may apply. Specifically, PPP and EIDL treat "small business concerns"3 and businesses with up to 500 employees as eligible borrowers, and each of the facilities under the Main Street Lending Program require that eligible borrowers have either (i) 15,000 or fewer employees or (ii) 2019 annual revenues of $5 billion or less. In calculating the number of employees, borrowers need to keep in mind rules such as the following:

  • As discussed above, the SBA's affiliation rules apply to many of the programs, so borrowers under those programs should treat the employees (and revenue) of all of their affiliates as their own. The SBA has clarified that this includes foreign affiliates for purposes of the PPP.4
  • Individuals employed on a full-time, part-time, or other basis are included, but volunteers are not.
  • For borrowers under the Main Street Lending Program and the PMCCF, a majority of the borrower's employees must be based in the United States. For the PMCCF, the Federal Reserve Bank of New York has clarified that it will not consider any parent company or sister affiliate.
  • The number of employees a borrower has is (for the Main Street Lending Program), or may be (for PPP), calculated using the borrower's (and its affiliates) average number of employees per pay period for the 12 completed months before the date the borrower's application is accepted.

3. If the company received a PPP loan, did the company have alternative sources of liquidity?

While the CARES Act exempts PPP loans from the requirement for typical SBA Section 7(a) loans that the borrower demonstrate that it cannot obtain credit elsewhere (known as the "Credit Elsewhere" rule), it includes in the certification requirements that borrowers certify that "[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant." After public outcry over receipt of PPP loans by certain public companies, the SBA, in consultation with the Treasury Department issued FAQ No. 31, which effectively turns the certification requirement into something that resembles the Credit Elsewhere rule. FAQ No. 31 provides that: "Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. For example, it is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith, and such a company should be prepared to demonstrate to SBA, upon request, the basis for its certification." Additionally, in FAQ No. 37, the SBA and Treasury Department confirmed that FAQ No. 31 applies to businesses "owned by private companies with adequate sources of liquidity to support the business's ongoing operations qualify for a PPP loan" by referring back to FAQ No. 31

The SBA has stated that, as a matter of enforcement discretion, it would not challenge this aspect of the certification of borrowers that repaid PPP loans by May 18, 2020. In addition, it indicated that it would not challenge this aspect of the certification for borrowers of less than $2 million, deeming their certification to have been made in good faith. The SBA has pledged to review all loans in excess of $2 million, and all other PPP loans as appropriate, including the basis of the borrower's certification of necessity.5

The SEC also appears to have focused on the certification requirement. The SEC's Division of Enforcement has issued letters to several public companies that received PPP loans eliciting information about the discrepancy between the tenor of their public disclosure and this certification requirement, which they needed to make to obtain the loans.6

This "necessity" certification requirement has become a very politicized issue that investors and acquirors will want to evaluate in connection with a transaction involving the recipient of a PPP loan.

4. Was the company eligible for the amount of funding it received?

All of the programs have caps on the amount of funding that a business may receive. For example:

  • PPP loans are capped at the lesser of (i) $10 million and (ii) the sum of (a) 2.5 times the average total monthly payments for "payroll costs" for the year prior to the loan date (different periods apply for borrowers that were not operational between February 15, 2019 and June 30, 2019, and for borrowers that employ seasonal workers), and (b) the outstanding amount of any EIDL loan made between January 31, 2020 and April 3, 2020 to be refinanced. "Payroll costs" are defined in the CARES Act, and exclude compensation of an employee in excess of an annual salary of $100,000 per year, as prorated for the covered period.
  • The Main Street Lending Program has caps on the amount of funding that a business may receive that are tied to a multiple of adjusted 2019 EBITDA. A Federal Reserve FAQ specifies how adjusted 2019 EBITDA is to be calculated for each facility. For MSNLF and MSPLF, it is based on the methodology previously used for adjusted 2019 EBITDA by the lender when extending credit to the borrower or to similarly situated borrowers. For MSELF it is the methodology previously used for adjusting EBITDA when originating or amending the underlying loan on or before April 24, 2020.

It is possible that PPP borrowers could overstate payroll costs, and borrowers under the Main Street Lending Program could overstate adjusted 2019 EBITDA, in violation of the certification requirements, in order to increase funding amounts.7

5. Did the company receive any other CARES Act funding and, if so, does that result in a loss of eligibility?

There are restrictions on borrowers obtaining funding under more than one program, such as the following:

  • Borrowers participating in PMCCF must not have received specific support pursuant to Subtitle A of Title IV of the CARES Act or any subsequent legislation (which means it must not have received a loan, loan guarantee or other investment from the Treasury Department under CARES Act §4003(b)(1) - (3)) and may not participate in any of the facilities under the Main Street Lending Program.
  • Borrowers that receive funding under one of the facilities in the Main Street Lending Program may receive multiple loans under the same facility, but may not participate in any other facility in the Main Street Lending Program or the PMCCF, or have received specific support pursuant to Subtitle A of Title IV of the CARES Act or any subsequent legislation.
  • Borrowers that have received an EIDL loan may not also receive a PPP loan if the EIDL loan was related to the COVID-19 outbreak unless the PPP loan was used to refinance the borrowers' existing EIDL loan.
  • Borrowers who have received EIDL or PPP loans are permitted to obtain subsequent funding under the Main Street Lending Program or the PMCCF.

6. Did the company's stockholders impact its eligibility for CARES Act funding?

Stockholders can impact eligibility for funding in a number of ways, such as the following:

  • Stockholders that are affiliates under SBA rules need to be factored into eligibility tests as described in part II.A.1 above.
  • Under general SBA rules applicable to PPP and EIDL loans, businesses that are not owned at least 51% by US citizens or lawful permanent residents and who control the management and daily operations of the business may be subject to additional criteria and/or be ineligible for loans.
  • Joint ventures with more than 49% participation by foreign business entities are not eligible for any of the facilities under the Main Street Lending Program.
  • With respect to the PMCCF, an issuer that is a subsidiary of a foreign company must use the proceeds derived from participation in the PMCCF only for the benefit of itself, its consolidated US subsidiaries, and other affiliates that are US businesses, and not for the benefit of its foreign affiliates.

The SBA has certain conflict of interest rules relating to stockholder ownership, that would apply to PPP and EIDL loans. In addition:

  • For borrowers under the Main Street Lending Program or PMCCF, a 20% or greater interest in the borrower cannot be held by the president or vice president of the United States, the heads of the executive branch departments, members of Congress or any of the foregoing's spouses, children or sons- or daughters-in-law. This is a statutory requirement from Title IV of the CARES Act.
  • Under the Main Street Lending Program, a business in which the lender or any of its associates own an equity interest of 30% or greater is disqualified, and businesses owned by an outside director of the lender or in which an associate of the lender owns an equity interest of less than 30% must comply with rules designed to prevent the business from receiving an undue advantage by virtue of such ownership.

B. Compliance with Loan Obligations; Loan Forgiveness

There are several obligations applicable to CARES Act funding, many of which are incorporated into the certification requirements for the funding programs. Investors and acquirors should consider diligencing obligations such as the following:

1. Has the company complied with restrictions on use of proceeds?

The various funding programs have restrictions such as the following:

  • Borrowers receiving PPP loans may only use the loan proceeds to cover payroll (e.g. salary, wages, commissions or tips, employee benefits, and state and local taxes), mortgage interest, rent, utilities and interest on debt obligations incurred before February 15, 2020. At least 75% of the proceeds must be used to cover payroll costs.
  • Borrowers receiving EIDL loans may use the proceeds for working capital purposes to carry the business until resumption of normal operations and for expenditures necessary to alleviate specific economic injury. A borrower cannot use EIDL loans to, e.g., expand its business, pay bonuses, pay dividends, repay stockholder loans, refinance long term debt, or pay penalties resulting from noncompliance with laws.
  • Borrowers under the Main Street Lending Program are prohibited from using the loan proceeds to repay other debt (with certain exceptions for the Main Street Priority Loan Facility, under which borrowers are permitted to refinance existing debt in certain circumstances).
  • Issuers under the PMCCF that are subsidiaries of foreign companies must use the funding for the benefit of US businesses.

Ideally, companies will have processes in place to demonstrate that the funds have only been used for permissible purposes.

2. Since receiving CARES Act funds, has the company conducted layoffs or reduced employee compensation or is there an intent to do so?

Maintaining the borrower's workforce and pre-crisis compensation levels is an important theme in several of the CARES Act loan programs. An acquiror or investor should consider whether the target company has conducted layoffs or reduced employee compensation following receipt of the relevant loan proceeds in light of the following (and the acquiror or investor should consider whether it has plans to implement any such actions following the acquisition or investment):

  • Under the PPP, a borrower's ability to obtain forgiveness of the full amount of the PPP loan will be impacted by its failure to maintain its workforce and compensation levels during the 8-week period following funding. An exception applies where the borrower eliminates the reduction in salaries or re-hires employees by June 30, 2020 (the borrower does not have to re-hire the same individuals it terminated).
  • Under each of the facilities in the Main Street Lending Program, the borrower must make commercially reasonable efforts to maintain its payroll and its employees during the term of the eligible loan (i.e., good faith efforts to maintain employees and payroll, in light of borrower's capacities, the economic environment, available resources and business need for labor).

3. Has the company increased executive compensation or is there an intent to do so?

Under Title IV of the CARES Act, subject to certain limited exceptions, a company that has received a loan or upsized an existing loan, as applicable, under any of the facilities in the Main Street Lending Program will be prohibited, from the time of origination until 12 months following maturity: (a) with respect to any employee whose total compensation in 2019 exceeded $425,000, from increasing the compensation of such employee or from paying such employee in severance more than two times the maximum total compensation received by such employee from the company in 2019, and (b) with respect to any employee whose total compensation in 2019 exceeded $3 million, from providing compensation to such employee in excess of the sum of $3 million plus 50% of the amount over $3 million that the individual received in 2019.

In addition to diligencing whether the company has violated these restrictions, acquirors and investors should consider how these restrictions will impact compensation planning post acquisition/investment, and their ability to incentivize the company's executives and highly paid employees following consummation of the transaction.

4. Has the company made capital distributions, paid dividends or repurchased its equity since receiving CARES Act funds or is there an intent to do so?

Borrowers under any of the facilities in the Main Street Lending Program are required to comply with section 4003(c)(3)(A)(ii) of the CARES Act, which, among other things, provides that a borrower shall not, during the term of the loan and for a period of one-year thereafter, (i) buy back equity securities of the borrower or any parent entity that are listed on a national securities exchange (unless required under a contract in effect prior to enactment of the CARES Act) or (ii) pay any dividend or make any capital distribution (with a limited exception for an S corporation or other tax pass-through entity). As with increases in executive compensation, this is both a diligence issue, with respect to the company's past actions, and a structuring issue, to ensure that the proposed transaction does not violate these restrictions either at or following closing.

5. Has the company used the proceeds of a CARES Act loan to pay other debt or is there an intent to do so?

A number of the loan programs under or expanded by the CARES Act include restrictions on the borrower's ability to repay existing debt:

  • Borrowers cannot use EIDL proceeds to refinance existing debt or to pay down loans owned by other federal agencies.
  • Recipients of PPP loans may use the proceeds to pay interest on debt obligations incurred prior to February 15, 2020, but repayment/refinancing of existing debt is prohibited.
  • With exception for borrowers refinancing existing debt from lenders other than a MSPLF lender in connection with the issuance of a loan under the MSPLF, borrowers under each of the facilities in the Main Street Lending Program must commit (a) to refrain from paying principal or interest on existing debt until the relevant Main Street loan is paid in full, unless the debt or interest payment is mandatory and due, and (b) not to seek to cancel or reduce any committed lines of credit with any lender.

6. Was the borrower eligible for any loan forgiveness that it obtained?

The principal amount of a PPP loan and any accrued interest may be forgiven, in whole or in part, subject to certain limitations. (There is no forgiveness for programs funded under Title IV of the CARES Act like the PMCCF and the Main Street Lending Program.)

  • The following expenses incurred by the borrower during the 8-week period after the PPP loan is disbursed are eligible for loan forgiveness: (i) payroll costs; (ii) interest on mortgage obligations incurred before February 15, 2020; (iii) rent payments for leases in force before February 15, 2020; and (iv) utility payments for service which began before February 15, 2020. Additionally, at least 75% of the loan forgiveness amount must have been used to pay payroll costs. Payroll costs exclude cash compensation of any individual employee in excess of $100,000 per year (prorated for the 8-week period after the PPP loan is disbursed) and certain other items.
  • The loan forgiveness amount is subject to reduction for (i) the amount of an EIDL Grant, (ii) reductions in full-time employee equivalents during the 8-week period following disbursement of the PPP loan relative to a specified prior period, or (iii) a reduction during the 8-week period following disbursement of the PPP loan, in an employee's total salary or wages in excess of 25% of the total salary or wages paid to the employee during the most recent full quarter in which the employee was employed before the 8-week period following disbursement of the PPP loan, subject to exceptions for employees with annualized salary or wages in excess of $100,000. Reductions in employee headcount and compensation between February 15, 2020 and April 26, 2020 can be disregarded (a) if the borrower rehires or eliminates salary reductions by June 30, 2020, or (b) under circumstances where a terminated employee declines to be rehired.

Borrowers must apply to their lenders for loan forgiveness and, in connection with the application, include a certification as to the truth and correctness of submitted documentation and as to the use of the funds for which forgiveness is sought.

C. Loan Requirements Implicated by a Sale of the Company

Often in M&A deals, outstanding loans of the target company will be repaid at Closing, and all obligations under the loans terminate. Acquirors should note, however, that some CARES Act funding programs subject borrowers to obligations that may continue after repayment.

1. Do any of the CARES Act funding programs contain restrictions on executive compensation that apply after loan repayment?

Yes. The Main Street Lending Program imports the restrictions on compensation from Sections 4003(c)(3)(A)(ii) and 4004 of the CARES Act (described in Section II.B.3 above), which apply during the period from execution of the loan until one year after repayment in full.

In an acquisition of a company that has accepted such funding, where all company debt is repaid at closing and the company remains in existence, the statutory language indicates that these obligations would continue to apply for a year post-closing. Acquirors and targets should be mindful of these obligations when structuring stay bonuses, management incentive packages and severance arrangements.

2. Do any of the CARES Act funding programs contain any other restrictions that expressly apply after loan repayment?

Yes. The Main Street Lending Program also imports the restrictions on capital distributions, dividends and equity repurchases from Section 4003(c)(3)(A)(ii) of the CARES Act (described in Part II.B.4 above), which apply during the period from execution of the loan until one year after repayment in full. These restrictions could be relevant for transaction structuring and could impact post-closing operations and reorganizations.

3. Are there any other CARES Act funding program requirements that may be impacted by a sale of the company?

Other obligations under the CARES Act funding programs to which the SBA affiliation rules apply may be relevant in M&A transactions, such as the following:

  • If loans are made to a company shortly before it is acquired, the acquisition may call into question whether the loan certifications were accurate when made. For example, borrowers under the PPP must certify that the "current economic uncertainty makes this loan necessary to support ongoing operations of the business." If stockholders cash out for a significant amount of money shortly after a loan is made, questions may arise, such as whether the stockholders could have found bridge funding, or whether the PPP loans were primarily used to get a higher valuation in a sale instead of to support ongoing operations. Questions like these could serve as the basis for challenging whether a certification was accurate when made.
  • Employee terminations may have similar implications under PPP loans. A central purpose of the program is to help companies meet payroll obligations, and loan recipients must certify that no more than 25% of the loan proceeds will be used for nonpayroll purposes. If a borrower is sold shortly after taking out PPP loans, and employees are terminated in connection with the acquisition, this undermines the purpose of the PPP and may lead to questions around the accuracy of the certification.  A similar issue arises under the Main Street Lending Program. Borrowers under the program are obligated to use commercially reasonable efforts to maintain payroll and retain employees during the time the loan is outstanding. If borrowers enter into acquisition agreements pursuant to which it is contemplated that employees will be terminated, there is a potential issue as to whether these obligations may be breached.
  • PPP loan forgiveness may also present issues. As indicated in Part II.B.6 above, borrowers under the PPP are eligible for loan forgiveness in an amount based on payroll costs, mortgage interest, rent and utility payments during the 8 week period after the loan is disbursed. If the loan has been forgiven prior to the sale of the borrower, the acquiror should consider the basis on which the forgiveness amount was calculated. The amount eligible for forgiveness is reduced if the borrower terminates employees during the 8 week period after the load is disbursed, but an exception applies if the borrower rehires employees or eliminates salary reductions by June 30, 2020. If an acquiror reverses any of the action that formed the basis of the exception, it is possible that the accuracy of the certification given in connection with loan forgiveness may be called into question.

The applicability of any of the above will depend on the particular facts of the acquisition and the borrower's loan. While the above do not constitute clear violations of the CARES Act funding programs, they could lead to the type of legal challenges, or become the subject of regulatory investigations and bad press, discussed in Part III below.

III. Legal Exposure Under the CARES Act

The CARES Act was designed to provide "fast and direct economic assistance for American workers, families and small businesses, and preserve jobs for our American industries."8  In order to provide this economic assistance as expeditiously as possible, the drafting process of the law was rushed. As a result, many of the requirements and obligations of the CARES Act are less than precise. Relying on agency guidance for clarification has been difficult as it is subject to varying interpretations. Ultimately, courts, investigators, prosecutors, and others are likely to interpret the various requirements and obligations of the CARES Act differently, particularly as they take a retrospective look and try to distinguish between those who made mere good-faith mistakes and others with more nefarious intent. The following describes how the CARES Act funding programs may be enforced, exposure for companies that have taken CARES Act funding and associated risks for acquirors and investors.

A. Enforcement Under the CARES Act

1. Who monitors and/or enforces compliance with the CARES Act?

The SBA Office of the Inspector General (SBA OIG) and the newly established Special Inspector General for Pandemic Recovery (SIGPR) are both armed with subpoena power and the authority to request and execute search and arrest warrants, and are charged to "conduct, supervise, and coordinate audits and investigations" of the Treasury Department's management of programs administrated under the CARES Act.9 As part of this directive, the SBA will automatically audit all loans exceeding $2 million and spot-check smaller loans distributed pursuant to the CARES Act.

The Congressional Oversight Commission
The CARES Act established the Congressional Oversight Commission to conduct oversight of the implementation of Subtitle A of Title IV of the CARES Act (under which the PMCCF and the Main Street Lending Program would fall) by the Treasury Department and the Federal Reserve, submit regular reports to Congress, and review implementation of Subtitle A by the federal government.10

The Pandemic Response Accountability Committee
The CARES Act also created and funded the Pandemic Response Accountability Committee (PRAC), the mission of which is to prevent and detect "fraud, waste, abuse, and mismanagement" in connection with funds distributed pursuant to the CARES Act and any other COVID-19 relief legislation, and mitigate "major risks that cut across program and agency boundaries."11

The Speaker of the House of Representatives has created the Select Committee on the Coronavirus Crisis, and several Representatives and Senators have called for hearings to review the SBA's administration of the relief programs and have also declared that they will use subpoena power to determine whether participants made false certifications.

The Attorney General
Even before passage of the CARES Act, the Attorney General had already directed the United States Attorneys "to prioritize the detection, investigation, and prosecution of all criminal conduct related to the current [COVID-19] pandemic."12

As described below, whistleblowers, called "relators," under the False Claims Act (FCA), have the ability to file "qui tam" complaints13  alleging violations of the FCA, for which they are eligible to receive a portion of any recovery. Employees, other individuals and entities, including even those specifically formed to pursue FCA actions, therefore have an incentive to initiate claims against companies for improperly obtaining and/or using CARES Act funding in violation of the CARES Act. Whistleblowers are also incentivized to provide information to other agencies, such as the SEC, in exchange for monetary rewards. And, as more information regarding the companies that have received CARES Act funding is shared publicly,14 such data will provide more avenues for relators and their counsel to probe looking for potential misconduct.

News Media
News organizations have also played a part in exposing violations of the CARES Act. When companies began to receive PPP loans, the media called out large public companies that received millions of dollars in PPP loans.15 Companies like Shake Shack and Potbelly, who each received $10 million PPP loans, were heavily criticized by the national news media. Following such criticism, the Department of the Treasury put out FAQ No. 31 that called into question the ability of large public companies to certify, as required by the PPP, that "current economic uncertainty [made the] loan request necessary to support . . . ongoing operations." In this instance, the media appears to have played a role in the eligibility criteria for PPP loans having been narrowed. The media has also played a role in exposing instances where borrowers have flagrantly violated the use of proceeds requirements for PPP loans.

B. Legal Exposure

Companies that knowingly make false statements in order to receive CARES Act loans have faced, and will continue to face, criminal prosecution from the various enforcement agencies mentioned above. Criminal convictions for fraud may result in fines of up to $1 million and/or imprisonment for up to thirty years.16  Management of companies could be subpoenaed to testify before Congress under oath. Companies may also face civil liability under the FCA. Because of the incentives it provides to private litigants and the lower preponderance of the evidence burden of proof that must be met, the civil FCA is likely to be the principal statute relied on for enforcement of CARES Act funding program requirements.17

1. What is the FCA?

The FCA was enacted in 1863 in order to provide the US federal government a mechanism to prosecute fraudsters selling defective goods for use by the Union Army during the Civil War. Concerns about fraud against the US government did not stop with the end of the Civil War. History shows that when the federal government opens its coffers to provide monetary relief during moments of national crisis, disasters, and epidemics, relief programs are accompanied by fraud. Predictably, FCA investigations spiked following Hurricane Katrina, the 2008 financial crisis, and the opioid epidemic. The Department of Justice has recovered on average $3.5 billion annually over the last decade for violations of the FCA, which it considers its "primary civil tool to redress false claims for federal funds and property."18 The annual figure spiked to nearly $6 billion in fiscal year 2014 driven by "an unprecedented $3.1 billion from banks and other financial institutions involved in making false claims for federally insured mortgage and loans" in the wake of the 2008 financial crises.19  It is widely expected that the CARES Act funding programs, which are over $2 trillion in aggregate amount and likely to grow even larger, will result in a slew of new FCA investigations.

2. Who may initiate an FCA claim?

There are two types of FCA claims: those initiated directly by the federal government, and "qui tam" complaints initiated by whistleblowers (or "relators"), alleging violations of the FCA. Qui tam complaints are filed under seal (not public) in federal court to allow the government to conduct its own investigation and determine whether to "intervene" in and litigate the case itself or to decline to intervene, in which case the relator has the option of pursuing the case on his own. The sealing requirement ostensibly has two purposes: first, to protect the integrity of the government's investigation and sources, and second, to protect the reputation of the defendant while the government conducts its investigation. By statute, cases are to remain under seal for 60 days, but in practice, courts typically allow cases to remain under seal for longer, and in some instances for several years. In return for their efforts, relators are entitled to receive a portion of any eventual recoveries, including settlements, except in rare circumstances. The relator's share is between 15-25% of the total recovery if the DOJ intervenes in the case and 25-30% of the total recovery if the DOJ declines to intervene. Relators are also entitled to receive their reasonable attorneys' fees and costs if a case results in any FCA recovery for the government.

3. What damages may the government seek for violations of the FCA?

Those that violate the FCA are liable for treble damages, i.e., three times the amount of damage sustained by the government as a result of the violation. Additionally, violations of the FCA can result in civil penalties of between $11,463 - $22,927 for each FCA violation.

4. What are the elements of an FCA claim?

Generally stated, liability under the FCA can be based on a showing that (i) a defendant presented a false claim for payment, (ii) the defendant did so knowingly, with deliberate ignorance, or in reckless disregard of the claim's falsity, and (iii) the falsity was material to the government's payment decision. Liability can be based on the making of false certifications or other false statements, but express and implied, in connection with receipt of federal funds. FCA claims could therefore be brought against companies for false certifications relating to eligibility for, or use of, CARES Act loans, or the forgiveness of PPP loans. See Annex A for a high level description of certification requirements under the various loan programs.

5. What is the statute of limitations for FCA claims?

The statute of limitations is 6 years from the date of the violation or 3 years from the date that the "responsible" government official knew or should have known of the material facts, but in no case more than 10 years after the violation occurred. Since qui tams can remain under seal for years during sometimes lengthy government investigations and given the long statute of limitations,20  it is not uncommon to see FCA actions finally reach their conclusion several years after the relevant conduct occurred, presenting challenges to reducing and mitigating acquisition and investment risk.

IV. Implications for Transactions

As indicated in Part III, there are very serious potential consequences for companies that have violated any of the requirements of the CARES Act funding programs. Implications for various aspects of the transaction process include the following:

A. Due Diligence

As with other deal due diligence, investors and acquirors will want to scale their diligence to the significance of the potential CARES Act funding violations in the overall transaction. Where there are no red flags indicating any compliance issues, it may be appropriate to ask a few confirmatory diligence questions regarding the types of issues flagged in this Advisory and, assuming satisfactory answers received, rely on representations and warranties (discussed below). Where there are red flags, such as a reason to doubt that eligibility criteria were properly evaluated, the company does not have the type of profile for which the funding program was targeted, or management generally evidences a poor compliance culture, then a deeper level of diligence may be appropriate. CARES Act funding that has been repaid or forgiven prior to the transaction should be evaluated, since repayment or forgiveness of the funding does not generally cure any compliance issue in obtaining it.

B. Structuring

There are several possible structuring implications for M&A transactions involving targets that have taken CARES Act funding

  • Where diligence reveals potentially material violations of law, there is the typical inquiry as to whether the transaction can be structured so as to leave the exposure behind, and/or the exposure can be ring-fenced so that it does not impact other parts of the acquiror's business.
  • Where funding under the Main Street Lending Program has been obtained, such that the restrictions on executive compensation and dividends and distributions apply, care should be taken to ensure that the transaction is not structured in a way to violate these provisions or to expand their application to the acquiror's operations.
  • Similarly, care should be taken in any integration planning stage to ensure that any CARES Act obligations that survive loan repayment are not violated in a post-closing internal restructuring.

C. Representations and Warranties

Representations and warranties should be scaled to the materiality of the funding to the borrower and the types of issues raised in diligence. Representations and warranties could be as brief as a sentence to the effect that the borrower has complied with all applicable contractual and legal obligations in connection with the application for, obtaining and use of CARES Act funding. In other situations, particularly where diligence has raised red flags, more granular representations and warranties focused on the specific issues of concern may be more appropriate.

D. Covenants and Conditions

Covenants and/or conditions focused on the CARES Act funding may be appropriate, such as a covenant not to take any action in violation of the applicable funding program, or a condition that no funding have been applied for or obtained under any of the Title IV programs (given that obligations under them survive repayment of the funds), or that no obligation for PPP loan forgiveness have been made.

Another possible condition is that the target company have returned the funding. SBA guidance and regulations provide that borrowers that applied for PPP loans prior to April 24, 2020 and repaid the loans in full by May 18, 2020 would be deemed to have made the loan application certification in good faith. Borrowers receiving loans of less than $2 million are also deemed to have made the certification regarding the necessity of the loan in good faith. The SBA has also indicated that in reviewing loans above that amount, if it determines that a borrower lacked an adequate basis for the certification and the borrower then repays the loan, the SBA will not pursue administrative enforcement or referrals to other agencies. But this is not the same as deeming the certifications to have been made in good faith, and does not prevent relators from bringing actions under the FCA. Moreover, it does not address borrowers voluntarily returning loans when the SBA has not made such a determination. Accordingly, a closing condition tied to loan repayment outside of a safe harbor may not be an effective risk mitigation mechanism for acquirors and investors.

E. Representations and Warranty Insurance/Special Escrow

For M&A deals involving representation and warranty insurance (RWI), an inquiry should be undertaken as to whether coverage for violations of law in connection with CARES Act funding would be excluded under the RWI policy. Coverage could be excluded, for example: (i) as a known loss where a potential violation of the CARES Act is discovered in due diligence, (ii) under a general fraud exclusion where the CARES Act violation results from fraud, or (iii) under a general exclusion for civil and criminal fines. Depending on the likelihood of exclusion, a special indemnity/escrow may be appropriate. Note that damages for reputational harm due to negative publicity are often very difficult to establish as the basis for a claim under an RWI policy or indemnity/escrow.

*As a technical matter, the Federal facilities described in parts I.C and D of this Advisory are under separate authority than the CARES Act. The Department of the Treasury committed to make equity contributions to approved Federal facilities, and these funds were allocated under the CARES Act, but the facilities themselves were not authorized or established under the CARES Act. The program described in part I.A also predates the CARES Act. For expediency, this Advisory will nonetheless refer to all of the programs as CARES Act funding programs.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

  1. On May 15, 2020, the House of Representatives passed the Health and Economic Recovery Omnibus Emergency Solutions Act (HEROES Act), which proposes several changes to the PPP, including, among others, extending the length of the program from June 30 to December 31, 2020, extending eligibility to all 501(c) nonprofit organizations, setting a minimum maturity on PPP loans of five years, and modifying certain loan forgiveness criteria, including, by extending the 8-week "covered period" following disbursement of a PPP loan to 24 weeks. It is unclear as of the date of this Advisory whether any of the proposed changes to the PPP will make it into any final bill approved by the Senate and signed by the President.

  2. The SBA's affiliation rules are set forth in 13 CFR § 121.301(f). Under the CARES Act and implementing SBA regulations, for purposes of PPP the affiliation rules are waived for some categories of businesses, including businesses in the accommodation or food services industry, certain franchises and entities that receive financial assistance from a company licensed under Section 301 of the Small Business Investment Act of 1958. The affiliation rules for the Main Street Lending Program are being imposed by the Federal Reserve, not by the CARES Act, and do not exempt those businesses.

  3. Whether a borrower qualifies as a "small business concern" is determined based on the headcount or annual receipts threshold applicable to the borrower's NAICS code as provided under existing SBA rules, including the headcount or receipts of the borrower's affiliates under the SBA's affiliation rules. Additionally, a business can qualify for the PPP as a small business concern without regard to the number of employees if it met both tests in SBA's "alternative size standard" as of March 27, 2020: (1) maximum tangible net worth of the business is not more than $15 million; and (2) the average net income after Federal income taxes (excluding any carry-over losses) of the business for the two full fiscal years before the date of the application is not more than $5 million.

  4. The SBA has indicated that borrowers who applied for loans prior to May 5, 2020 will not be ineligible based on their excluding non-US employees in determining whether they complied with the applicable headcount threshold.

  5. In FAQ No. 46, the SBA stated: "If SBA determines in the course of its review that a borrower lacked an adequate basis for the required certification concerning the necessity of the loan request, SBA will seek repayment of the outstanding PPP loan balance and will inform the lender that the borrower is not eligible for loan forgiveness. If the borrower repays the loan after receiving notification from SBA, SBA will not pursue administrative enforcement or referrals to other agencies based on its determination with respect to the certification concerning necessity of the loan request." Note that this does not foreclose the possibility of False Claims Act claims based on a false certification.

  6. See, e.g. U.S. securities regulator scrutinizes public companies that took emergency loans: sources, Reuters Article by Koh Gui Qinq, May 14, 2020.

  7. There is indication that the Department of Justice Fraud Section may be investigating potential overstatement of payroll costs by loan applicants. Justice Department Sees Early Fraud Signs in SBA Loan Flurry, Bloomberg Article by Tom Schoenberg and Christian Berthelsen, Apr. 30, 2020.

  8. The CARES Act Works for All Americans, U.S. Department of the Treasury, accessed May 24, 2020.

  9. Pub. L. 116-136, §4018(c).

  10. Pub. L. 116-136, §4020.

  11. Pub. L. 116-136, §15010(b).

  12. Memorandum For All United States Attorneys re COVID-19 - Department of Justice Priorities, Office of the Attorney General, Memorandum, Mar. 16, 2020.

  13. Qui tam is an abbreviation of a Latin phrase meaning "he who pursues this action on our Lord the King's behalf as well as his own."

  14. "This page will display other detailed information on federal spending related to COVID-19, including…{r}elevant operational, economic, financial, grant, subgrant, contract, subcontract and other information on recipients of COVID-19 funds." Track the Money, Pandemic Response Accountability Committee, accessed May 21, 2020.

  15. "Unfortunately, many large companies were able to utilize this program and obtained loans that were intended for small businesses." In First Official Action, House Coronavirus Panel Demands That Large Public Corporations Return Taxpayer Funds Intended for Small Businesses, Press Release for Congressman Andy Kim, May 8, 2020.

  16. For fraud of a federally insured institution, as prescribed by 18 U.S.C. § 1014.

  17. However, numerous criminal antifraud and false statements statutes could be used by the government to prosecute alleged violators, including statutes prohibiting theft or bribery concerning federal programs (18 U.S.C. § 666), false statements (18 U.S.C. § 1001), bank fraud (18 U.S.C. § 1344), wire fraud (18 U.S.C. § 1344), securities fraud (18 U.S.C. § 1348), fraud against the United States (18 U.S.C. § 371), money laundering (18 U.S.C. §§ 1956 and 1957) and others.

  18. Justice Department Recovers over $3 Billion from False Claims Act Cases in Fiscal Year 2019, Department of Justice, Office of Public Affairs, Jan. 9, 2020.

  19. Justice Department Recovers Nearly $6 Billion from False Claims Act Cases in Fiscal Year 2014, Department of Justice, Office of Public Affairs, Nov. 20, 2014.

  20. Although the defendant typically does not know of an FCA lawsuit filed under seal, that filing nevertheless halts the running of the statute of limitations.