SBA Affiliate Rules CARES Act

150 150 Karr Tuttle Campbell

As of publishing, there appears to be a concerted effort by industry and at least some elements of Congress to broaden the exemption of the application of the “affiliate rules” described below so that much of the analysis below would become moot. Yesterday, Speaker Pelosi’s office sent a letter to the Treasury Department urging them to do exactly that in implementing the Paycheck Protection Program.11 Nonetheless we’ve received numerous inquiries from our private equity, independent sponsor and venture capital-backed clients concerning the application of existing affiliation rules and how they may or may not prohibit the portfolio companies of those clients from accessing Paycheck Protection Program funds. As such, we’ve prepared this alert to assist in evaluating whether or not your particular portfolio of businesses will be impacted by the affiliate rules.

Affiliate Rules – In General

Earlier this week, we discussed the extensive financial assistance that may be available to small businesses under the new Small Business Administration (“SBA”) lending programs, as expanded by the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”).22 In this update, we will discuss the SBA’s affiliate rules, which are critical to the success or failure of most SBA loan applications. Generally, when applying for an SBA loan under a CARES Act program, applicants will need to self-identify any “affiliate” entities or individuals. Identifying affiliates is crucial because the SBA affiliate rules aggregate certain entities and individuals to figure out whether an applicant is “small enough” to qualify for financial assistance. To qualify for a loan under the CARES Act, applicants must have not more than the greater of 500 employees or, if applicable, the size standard in number of employees established by the SBA for the industry in which the applicant operates.33 Due to the current affiliation rules, loan applicants may be surprised to learn that they are too big to qualify.

Example Scenario

In analyzing this issue, we will focus on how the SBA affiliate rules apply to independent sponsors and their portfolio companies. We will assume that these portfolio companies are seeking a 7(a) Business Loan under the CARES Act Paycheck Protection Program, and we will assume the following example structure:

Sponsor Capital is an independent sponsor that “owns” three portfolio companies, “ A”, “B”, and “C”. Sponsor Capital formed three special purpose funds to assemble the equity for each of the portfolio companies (“Fund A”, “Fund B”, and “Fund C”). Each of the Fund entities is owned by groups of individual investors. Sponsor Capital also has an equity stake in each fund entity, but in each case it individually owns less than 50% of each Fund entity. Each of the Fund entities in turn owns 100% of the equity an operating company (“OpCo A”, “OpCo B”, and “OpCo C”). In each case, the same individual from Sponsor Capital is one member of a multiple person Board of each Fund entity, and the remainder of those Boards are populated by a mix of investor and operator appointees. Each of the Fund entities is structured so that the investors have certain veto rights over the actions of the Fund entity and its respective operating company.
Are OpCo’s A, B, and C affiliates?

Narrow Waiver of Affiliate Rules Under the CARES Act

To begin, it is important to note that the CARES Act does provide a narrow waiver of the SBA affiliation rules. However, as explained in our prior update, this waiver only applies to accommodation and food service businesses, franchises, and certain businesses that receive financial assistance from a Small Business Investment Company. Thus, most portfolio companies will still be subject to the affiliate rules.

Which Affiliate Rules Apply Today?

The CARES Act refers to 13 CFR 121.103 whenever it refers to affiliate rules.44  This SBA regulation provides some general principles of affiliation but notes that for applicants in SBA’s Business Loan, Disaster Loan, and Surety Bond Guarantee Programs, the size standards and bases for affiliation are set forth in 13 CFR 121.301. 13 CFR 121.301 was most recently updated via an interim final rule entitled “Express Loan Programs; Affiliation Standards”, dated effective March 11, 2020.55  However, the CARES Act rescinded this rule.66

Given that the CARES Act rescinded the new affiliate rule, we revert to the prior version of 13 CFR 121.301, released in 2016.77  Under the 2016 affiliate rules, affiliation can arise in the following ways:88

  1. Affiliation based on ownership: A business concern is an affiliate of an individual, concern, or entity that owns or has the power to control more than 50 percent of the concern’s voting equity. SBA will deem a minority shareholder to be in control if such shareholder has the ability to prevent a quorum or otherwise block action by the board of directors or shareholders.
  2. Affiliation arising under stock options, convertible securities, and agreements to merge: In evaluating equity ownership percentage, SBA evaluates all convertible securities on a fully diluted basis.
  3. Affiliation based on management: Affiliation arises where the CEO or President of
    the applicant concern (or other officers, managing members, or partners who control the management of the concern) also controls the management of one or more other concerns. Similarly, affiliation arises where a single individual, concern, or entity that controls the board of directors or management of one concern also controls the board of directors or management of one or more other concerns. Finally, management affiliation can arise where a single individual, concern or entity controls the management of the applicant concern through a management agreement.
  4. Affiliation based on identity of interest: Affiliation arises when there is an identity of interest between close relatives who have substantially identical business or economic interests (e.g., where the close relatives operate concerns in the same or similar industry in the same geographic area).
  5. Affiliation based on franchise and license agreements: Generally, the restraints imposed on a franchisee or licensee by its franchise or license agreement will not be considered in determining whether the franchisor or licensor is affiliated with an applicant franchisee or licensee, provided that, the applicant franchisee or licensee has the right to profit from its efforts and bears the risk of loss commensurate with ownership.

What are the Implications of the Current Affiliate Rules?

Control is Key; Control Can Extend Up the Entire Chain of Ownership

First, it is important to note that affiliate analysis is fundamentally a qualitative “control” analysis. Thus, there is no bright line at which the SBA will stop looking up the chain of ownership. This is evidenced by the language of the regulation: the key is whether one entity owns or has the power to control more than 50% of the applicant concern’s voting equity. Thus, if at any point in the chain of ownership there is an entity that has the power to control the applicant concern, then the applicant concern is potentially affiliated with such entity. Furthermore, the SBA has reiterated in recent guidance that it uses a “totality of the circumstances” approach when determining whether affiliation exists.99  In fact, the SBA maintains that it may find affiliation based on the totality of the circumstances even though no single factor alone may be sufficient to constitute affiliation. Therefore, there is no bright line  threshold at which an applicant portfolio company can be absolutely sure that it will not be deemed to be affiliated with Sponsor Capital.

Moreover, SBA Form 355, which the SBA has historically used to gather the relevant information for size determination for most of its programs states the following: “If the applicant is owned by one or more entities (i.e., not individuals), provide the name of all owners of the entities and their percentage of ownership. This information must be provided for owners of all entities until the applicant identifies the ultimate owners who are natural persons.”1010

Therefore, in our Sponsor Capital example, OpCo’s A, B and C are not saved from a finding of affiliation simply because Sponsor Capital owns less than 50% of each Fund Entity.

Control Analysis is Fact Specific; Control of Day-to-Day Operations is Important

Beyond the 50% ownership test, most of the current SBA affiliation rules are fact intensive control analyses. The rules do provide some direct guidance. For example, we know that if Sponsor Capital has a veto right that enables it to block a quorum of the shareholders of Fund A from acting with respect to certain matters, then Sponsor Capital effectively controls OpCo A from acting with respect to those matters. This is a strong indication of affiliation, though the specific veto right matters. Similarly, in evaluating control via a management agreement, the specific management rights matter. Thus, there
are a wide swathe of possible minority shareholder (or single director) control rights that may constitute control.

The SBA rules do not specify all the specific instances in which such minority rights constitute control. Most practitioners look to SBA Office of Hearing and Appeals (“OHA”) administrative case law to find guidance as to which types of covenants and investor rights are likely to create affiliation.1111 Generally, experts agree that the case law indicates that a minority owner is more likely to be deemed to have control if such owner has the ability to block day-to-day operational decisions of the applicant company. The National Venture Capital Association has published the following summary1212 of current SBA OHA case law, which tends to show that a minority investor’s ability to do or block any of the following company actions (including via a director with a veto right), will create affiliation:

  • Making, declaring, or paying distributions or dividends other than tax distributions.
  • Establishing a quorum at a meeting of stockholders (and likely at a meeting of the board).
  • Approving or making changes to the company’s budget or approving capital expenditures outside the budget.
  • Determining employee compensation.
  • Hiring and firing officers and executives.
  • Blocking changes in the company’s strategic direction.
  • Establishing or amending an incentive or employee stock ownership plan.
  • Incurring or guaranteeing debts or obligations.
  • Initiating or defending a lawsuit.
  • Entering into contracts or joint ventures.
  • Amending or terminating leases.

By contrast, the SBA sometimes finds that minority investor rights that are tailored towards controlling extraordinary decisions do not create affiliation. The NVCA has also provided a summary of such rights, which have been found not to create affiliation on at least one occasion:

  • Consent right with respect to the sale of all or substantially all of the company’s assets.
  • Placing an encumbrance or lien on all or substantially all of the company’s assets.
  • Engaging in any action that could result in a change in the amount or character of a company’s capital contributions.
  • Changing the company’s line of business.
  • Engaging in a merger transaction.
  • Issuing additional stock/equity.
  • Amending the organizational documents of a company.
  • Filing for bankruptcy.
  • Amending the governing documents to materially alter the rights of existing owners.
  • Dissolving the company.
  • Increasing, decreasing, or reclassifying the authorized capital of the company.
  • Increasing or decreasing the size of the board.
  • Entering into a confession of judgment.
  • Disposing of the goodwill of the company.
  • Committing to take any action that would make it impossible for the company to carry on its ordinary course of business.

In summary, control over day-to-day operations is likely to lead to a finding of affiliation. However, it is important to remember that no one factor is dispositive. The SBA always retains the authority to analyze affiliation under a totality of the circumstances approach.

What About a Group of Affiliates Where Each Affiliate Operates in a Different Industry?

Let’s assume OpCo’s A, B and C are affiliated, but that they each operate in entirely different industries. Does each company still need to count the employees of its “affiliate” in determining its size? The short answer is yes, though it is unclear whether the typical process will be modified with respect to loans applied for under the Paycheck Protection Program.

Historically, an applicant company has had to include all employees of domestic and foreign affiliates when calculating its size.1313  Then, the company would look up the relevant SBA size standard for its primary industry to find out how many employees (or in some cases, what amount of gross receipts) it could have to be considered a small business.1414  A company’s primary industry was determined by reviewing the distribution of receipts, employees and costs of doing business among the different industries in which the company had operations for the most recently completed fiscal year.1515  With respect to affiliate groups that have businesses that operate in different industries, the term ‘primary industry’ has meant the work that accounts for the greatest percentage of the aggregated receipts of those affiliates. 1616

Thus, theoretically, OpCo A, B and C would each need to count the others’ employees in their size determinations. Then, they would need to discern which entity accounted for the largest percentage of gross revenue amongst the three. That entity’s primary industry would then define the primary industry size standard to be used for each entity in the affiliate group. Presumably, the analysis would be similar under the Paycheck Protection Program, except that if the affiliate group’s industry-specific size cap was less than 500 employees, the affiliate group could use the greater (slightly more favorable) 500-employee size cap instead.

Of course, this analysis is clunky and not suited to the economic realities of companies like OpCo’s A, B and C. Nevertheless, this calculation difficulty illustrates the general point that SBA lending has not historically been well suited to independent sponsors with diversified (but controlled) portfolios. Sponsors should speak with SBA lenders to develop practical strategies for determining affiliate group employee counts. Additionally, forthcoming rules from the SBA may clarify this issue or waive the affiliate analysis entirely, at least with respect to Paycheck Protection Program loans.

KTC’s Business & Finance attorneys are available to assist you with your specific questions.

This Client Alert was prepared by Michael Rebagliati and Stephen S. McKay.

[1] https://www.speaker.gov/newsroom/33120-0 
[2] Prior KTC SBA CARES Act Client Alert
[3] https://www.sba.gov/document/support–table-size-standards
[4] See, e.g., Sec. 1102(a)(2)(36)(A)(vi); CFR 121.103.
[5] Though the title of the rule only mentions Express Loan Programs, the background information within clarifies that most SBA Business Loans (including 7(a) Loans and Economic Injury Disaster Loans) were affected. These new rules would have made the affiliate threshold more challenging in some ways (see, e.g., the discussion re: Newly Organized Concerns).
[6] See Sec. 1102(e) (Interim Rule).

[7] The prior version is the 2016 version. The Summary of Comments to the 2016 version explains that this is the version where the SBA decided to move affiliation rules for Business Loans and Disaster Loans to 13 CFR 121.301(f) in order to distinguish them from affiliation requirements for other SBA programs (e.g., government contracting).
[8] The following language summarizes the language in the rule.
[9]https://www.sba.gov/sites/default/files/2018-07/2018-07-13%20AFFILIATION%20GUIDE_Updated%20%281%29.pdf
[10] SBA Form 355
[11] As explained in this NVCA guide, the available administrative case law is actually based on similar, but distinct,
affiliation regulations. This is because most of the case law is focused on resolving disputes in other SBA programs (especially government contracting, where contractors can contest bid awards). The affiliation rules are similar, and most experts seem to consider the case law relevant. Nevertheless, it is important to note the difference. One reason that there is not significant case law relating to loan eligibility is that loan eligibility is not typically litigated in the way that government contract awards and other programs are. Thus, there is not a directly on point public record of fact-specific examples to look at when analyzing loan eligibility affiliation questions. Experienced 7(a) lenders are likely the best situated to explain how this analysis plays out in practice.
[12] NVCA Summary.
[13] 13 CFR 121.106.
[14] 13 CFR 121.101; note that the Paycheck Protection Program breaks with past processes in that it presents an alternative size cap – a company applying for a loan under the PPP either needs to have 500 or less employees, or not more employees than as defined in the applicable industry size cap (whichever is greater).
[15] 13 CFR 121.107; note that, depending on the SBA program in question, the company might be making this determination, the lender might be making this determination, or the SBA itself (e.g., a government contracting officer), might be making this determination.
[16] See SBA No. SIZ-5222.

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