If we did not have enough to worry about during the pandemic, now the Treasury added a standard to the Paycheck Protection Program (PPP) regarding eligibility based on liquidity and access to capital.
This new standard has created a great deal of concern among businesses that still operated in full or limited capacity during the crisis. This concern has been magnified by the banks protecting themselves through notices to its customers outlining all the bad things (penalties, fines, criminal charges, etc.) that will happen if you do not meet these new standards.
Further complicating this matter is the lack of guidance provided by Treasury. During the pandemic, Treasury wrote a series of Frequently Asked Questions (“FAQs”), which are updated often, as our primary source of information about the PPP loan program. On April 23, 2020, Treasury added the sublime Question 31 which states:
Question: Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?
Answer: In addition to reviewing applicable affiliation rules to determine eligibility, all borrowers must assess their economic need for a PPP loan under the standard established by the CARES Act and the PPP regulations at the time of the loan application. Although the CARES Act suspends the ordinary requirement that borrowers must be unable to obtain credit elsewhere (as defined in section 3(h) of the Small Business Act), borrowers still must certify in good faith that their PPP loan request is necessary. Specifically, before submitting a PPP application, all borrowers should review carefully the required certification that “current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” 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. (…)
There are so many ill-defined words in this statement it is impossible to comprehend none the less determine if you are eligible. The words seem subjective and maybe that was the intent. Ancient philosophers would struggle with making sense of its meaning. I am no philosopher, but I should be qualified to interpret what this means. So, I foolishly began the process of dissecting the wisdom handed down by Treasury.
“…good faith that their PPP loan request is necessary.”
Well, I was not off to a good start. What exactly is good faith? Generally, the term means acting honestly and fairly based on the context of the situation. The lawyers will surely argue this word in depth once a claim arises under this rule. Since it is hard to know if some acted in “good faith” it is usually much easier to determine if someone acted in “bad faith” or intentionally dishonest. Based on all the uncertainty regarding these rules, unless you intentionally committed fraud or acted in “bad faith” this should be the easiest standard to satisfy.
As long as you acted in “good faith” you should not fear the dreaded “criminal action” stick wielded often by Treasury and the banks.
Necessary? Alan Gassman wrote a great article earlier this week for Forbes. Mr. Gassman tracks the legislative history of the vagueness of the word starting with the Supreme Court case of McCulluch v. State in 1819. Subject to significant debate by legal scholars, this is a very low standard and should be easy for most businesses to satisfy.
We cleared the first hurdle, pending lots of legal debates. However, it seems as though with little effort we can demonstrate that we acted in good faith and that the loan was necessary.
“current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.”
This seemed straight forward. “Current economic uncertainty” seems easy enough but my curiosity got the better of me. There are two paramount theories that make this an easy standard to satisfy. First, “Knightian Uncertainty” was developed by economist Frank Knight in his 1921 book “Risk, Uncertainty and Profit”. The theory is that there is unquantifiable knowledge about some possible occurrence (unpredictable future events like a pandemic), opposed to the presence of quantifiable risk. Second, is the “Black Swan Theory” developed by Nassim Nicholas Taleb in his 2007 book “The Black Swan”. The theory explains the disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology as well as the non-computability of the probability of the consequential rare events using scientific methods (small probabilities). Both widely accepted theories give rise to our ability to satisfy the “current economic uncertainty” standard.
Does this economic uncertainty impact how you “support the ongoing operations” of your business? In reviewing this, I get caught up on the word “ongoing.” Generally, the word means continuing but considering current events over what period? It is our opinion that based on the level of “economic uncertainty,” as substantiated by Knight and Taleb, ongoing means continuing your business into the foreseeable future. Based on the level of uncertainty, this will mean a change to your business model and financial fundamentals in order to take reasonable actions maintain “ongoing operations.” This is a subjective standard but with financial models the necessity of the loan should easily demonstratable.
“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.”
This is the standard that has us concerned. The CARES Act removed the clear “credit elsewhere” standard which provided that if you cannot get a loan somewhere else then you qualify. Instead, Treasury opted to replace that clear standard with the more subjective “…access other sources of liquidity…”test. This is a factor-based test with a much lower standard than the clear “credit elsewhere” rule.
We think that the layman’s interpretation of this is simply, do you have enough money (or access to money such as credit or public markets) to operate as you did before the crisis for the near future based on the current economic uncertainty?
Steps to Take
The basis of these rules is that you acted in good faith and that at the time you made the loan application (or April 23rd if later) the loan was necessary to support ongoing operations. It is critical that you document your determination so that future events do not distort your determination at the time the loan application was made. Here is what you should document:
- Prepare an anecdotal overview of all the factors impacting your business
- Outline the current economic impacts on your business including sales, expected increase expenses, remote work force, etc.
- Outline your current debt structure along with available lines of credit and investors
- Prepare liquidity ratios for your current and historical business. These are financial ratios such as current ratio, quick ratio, operating cash flow ratio and cash conversion cycle. These ratios mathematically demonstrate the cash health of the business.
- Prepare high level financial models of the business over the next 2 years.
- Based on the level of uncertainty sales projections should be low and increased expenditures for new business requirements should be included.
- Since the PPP loan repayment period is over 2 years, we believe this is the correct period for “ongoing” operations.
- Incorporate liquidity ratios into the projections to show not only historical cash needs but cash requirements under the current economic uncertainty.
- Outline any other factors or probable risk (not “black swans”) that your business can experience.
If you are unable to make the determination, then please contact us or your CPA firm along with your lawyer to help make a reasonable determination. However, if you find that you cannot satisfy this requirement than you can return the funds by May 14, 2020 (FAQ #43) to avoid punitive actions.
The Treasury has continued to emphasize and expand their focus on these rules. These rules apply to all businesses (FAQ #37 published on April 28, 2020) and it is Treasury’s intent to review all PPP loans in excess of #2 million (FAQ #39 published on April 29, 2020).
The Treasury will certainly focus on abuses of these loans. We believe every business, regardless of size, should take the steps outlined above and be prepared to demonstrate why the loan was “necessary to support ongoing operations.”