SBA PPP: New IFR on Related Parties Creates SNAFU for Middle Market PPP Borrowers

The more guidance we come across, the more problems we see.  SBA today released a newIFR  today that so amazingly misunderstands the nature of the ownership of today’s small businesses that it creates a remarkable cluster [situation] even by SBA PPP standards.  It may effectively render rent and mortgage interest payments nonforgivable for most borrowers because it remains stuck in a 1960s-era understanding of small business ownership.

The IFR is so bizarre that I had to put it down and step away for a day to come back and read it again.  In the meantime, a manager on our Matter Planning and Pricing Team (and who is one of the brightest young minds in our firm) inadvertently flagged an old article for me entitled “The Difference Between a SNAFU, a ****show, and a Cluster[Situation].”   One of the partners who mentored me as a young lawyer frequently described problematic deals as “cluster … situations,” so I’ll use that term here.  (I hope those of you old enough to remember Hank are smiling.)  The article itself does NOT mince words, so read at your own peril.  

Before diving into the details of the IFR, a couple quick situational updates:

·         The forgiveness portal is open, but manybanks still have not begun accepting applications and even borrowers who are able to apply are holding off.  It seems both groups are still hoping for a legislative or regulatory solution that will simplify and streamline the process, perhaps even providing some automatic forgiveness.

·         M&A deal flow involving PPP borrowers is charging ahead, with parties adopting some of the structures outlined in ourNote.  One challenge is that most RWI insurers are taking fairly broad exclusions for COVID-related matters, including CARES Act stimulus programs like PPP.  However, there are new insurance products coming online specifically providing coverage for PPP and other risks.  Stay tuned for a webinar from us on these topics in the near future.

So, on to the analysis of IFR 24, though it’s hard to know where to begin in critiquing this thing.

·         First, it applies the ownership compensation limits to all owners of any equity of a business, except for owners of less than a 5% “ownership stake” of a C-corp or an S-corp.

o   Yes.  That means that an owner of literally ANY interest in an LLC or partnership is subject to the owner compensation limits.  (Your regional deputy VP has a 0.0001% profits interest in the LLC?  Too bad, she’s an “owner” and subject to the comp limits)

o   No, there is absolutely no guidance on what an “ownership stake” means.  So we don’t know whether it is calculated on a fully-diluted basis, whether it would include just management options or even indirect ownership through a holding company, partnership, trust or other vehicle.  So, no we don’t know to whom this applies.

o   The ownership comp limits are fairly complicated, but they generally limit the forgivable amount to $15,385 per “owner” to a borrower using an 8-week forgiveness period (8/52 of $100k) or $20,833 for a borrower using a 24-week period (2.5/12), or the same fraction of the owner’s 2019 comp, if lower, with additional limits on the treatment of health insurance and other benefits.

·         Borrowers are not permitted to deduct expenses relating to subleased space, with the IFR using the example of a borrower who subleases 25% of its rented space being able to get forgiveness for only 75% of its lease expense or mortgage interest.  Although that fraction is to be calculated on the FMV of the subleased space, it apparently doesn’t matter whether the sublessor is paying significantly more or less than the borrower’s actual pro rata rental cost or mortgage interest on such space.

·          If you’re working from home, sorry, you cannot count any “household expenses” toward forgiveness.

·         The owner rules are terribly drafted and the sublease/household rules are at best curious, but they are actually the least objectionable parts of the new IFR.  The new limits on related-party expenses are … well, they are very model of a modern major cluster situation.  

o   Before analyzing them, it may be helpful to pause for a moment and remember that SBA in many aspects is still stuck in the 1960s.  They still think of small businesses as being owned by Ozzie and Harriett, and never seem to have progressed out of that mindset to recognize that many of today’s small businesses are in fact middle market companies that participate in modern and complex debt and equity financing structures in order to help such businesses grow and thrive.  By and large, SBA regulations have been slow to adapt, if they have adapated at all, to this new reality.  Keep in mind that it was only a few years ago that SBA relaxed the “double-holdco rule” that prohibited SBICs from financing businesses that had more than one holding company above the operating company(ies), because such holding companies were deemed “passive.”  (You can now have two holdcos … but not three.  Oh, and don’t even think about forming a blocker corp for an SBIC without SBA permission.)

·         Turning to the new related-party rules, the IFR provides that a business can get forgiveness for rent payments to such a “related party” only if the rent is no more than the amount of mortgage interest owed by the related-party landlord (to its lender(s)) on the applicable property during the covered period.  However, “mortgage interest payments to a related party are not eligible for forgiveness.”

·         We’ve all done deals where the business owners separately own the business’s main operating or office facility through a separate vehicle.  So, at one level, the intent of these rules is understandable, presumably seeking to prevent small businesses from getting forgiveness for above-market payments to related landlords or landers.  But the IFR does NOT focus on ABOVE-MARKET payments.  Rather rent and interest payments are limited even if they are at or below market rates.  This is somewhat foolhardy, but could be perhaps rationalized by the goal of having simple rules that don’t require market studies, etc. 

·         Of course, if you’re a business owner who has had such an arrangement in place for years and has paid off your mortgage, that’s too bad.  No rent forgiveness for you.  The logic here seems to follow the 2008-era stimulus rules that many said rewarded the least prudent borrowers.

·         However, that’s still not the worst of it.  the SBA shows its Ozzie and Harriet roots and time-capsule thinking when it declares “Any ownership in common between the business and the property owner is a related party for these purposes.”  Aside from being grammatically challenged, this rule is an interpretative and operational disaster.  “Any ownership in common.”  … “ANY ownership” … “ANY”!?!  This is, truly, a cluster situation.

o   We noted below the Forgiveness FAQ #4 seems to allow forgiveness of interested on debt secured by traditional liens on personal property (using the “auto loan”) example, which opens the door for forgiveness on debt owned by many PE portfolio companies.  However, it is not uncommon for the providers of such debt to also make a minority equity coinvestment in the portfolio company.  IFR 24 renders interest on such debt unforgivable because of the “ownership in common.” 

o   But it gets still worse.  Approximately 400 public companies and an untold number of companies backed by PE, VC or other institutional investors received and retained PPP loans.  Picture such a business that rents office space in a building owned by an unaffiliated (in any reasonable interpretation of the word) large commercial REIT or other institutional investor.  It is literally impossible for those business to even know if they have any “ownership in common”with their landlords, or what portion of the landlord’s mortgage interest might apply to their leased space.  Too bad.  If there is ownership in common, such rent is now not forgivable.

o   The same issue applies to businesses with true arm’s-length debt.  Any business with institutional ownership likely has one or more investors who hold a small equity position in the bank or other lender providing such debt.   Too bad.  The interest on such debt is now not forgivable.

o   Now, to be fair, the rule is not clear that it applies to an indirect ownership in common.  However, the rule would also capture a family-owned business.  Imagine two businesses, one with a lease in a local office building owned by, say Cousins Properties (I mean the REIT, not the uncle’s kids), and one which owns its facility, subject to a mortgage loan from, say, JP Morgan Chase.  If any one of the business’s family owners owns even one single share of the millions of shares of publicly-traded CUZ or JPMC stock … too bad, the rent or mortgage interest is not forgivable.

·         You will be shocked, shocked to hear that this has not been well received. 

o   Forbes has called the rule both shocking and “unforgivable” (well, okalmost unforgivable”):

“Many borrowers will be shocked to find out that expenses paid pursuant to arm’s length lease or debt arrangements with related parties that have been in place for many years will now not be counted towards forgiveness.”

o I don’t know whether they intentionally were channeling Biggie (with tax lawyers/accountants one can never know), but the first sentence of this email was inspired by an article on TaxNotes entitled “More Guidance, More Problems for PPP Borrowers.” It’s behind a paywall, but it strikes the same chord as this email, albeit more politely and eruditely.

Interestingly, the second Forbes article suggests that rather than continuing to wait for help from Congress as noted above, borrowers may now want to apply forgiveness sooner rather than later, before SBA can make a further mess out of this.  However, this clearly is not, CANNOT be, what SBA intended.  Yet, somehow it is what they not only wrote, but actually published.  I’ve generally tried to avoid politics in this column, but this tweet regarding a US Supreme Court decision earlier this year has resonated throughout the PPP process, but never more appropriately than now:

Despite that, I have to believe that this interpretation based on ownership structures from the Ozzie & Harriet era will get “clarified” soon to fix this issue.  I mean, it has to, right?  In the words of Terence Mann “You’re from the sixties …. Out!  Back! There’s no place for you here in the future.”

Sigh. Once again, stay tuned.