On April 3, 2020, the U.S. Department of the Treasury (Treasury) and U.S. Small Business Administration (SBA) released further guidance on the affiliation rules applicable to the Paycheck Protection Program (PPP), as enacted under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, via the Treasury’s Applicable Affiliation Rules fact sheet and the SBA’s Second Interim Final Rule[1] (collectively, the Updated Affiliation Guidance). The Updated Affiliation Guidance is supplemental to the SBA’s First Interim Final Rule that was issued on April 2, 2020.

Foremost, the Updated Affiliation Guidance confirms the view of a growing number of market participants (notwithstanding express language in the CARES Act that suggested the contrary), which is that the SBA’s affiliation rules for the PPP should be analyzed under the purview of 13 CFR 121.301 and not 13 CFR 121.103.[2] Further, the Updated Affiliation Guidance waives the application of affiliation rules under 13 CFR 121.301 for (i) any business concern in the hospitality and dining industry designated as such under Sector 72 of the North American Industry Classification System that employs not more than 500 employees[3], (ii) any business concern operating as a franchise that is assigned a franchise identifier code by the SBA and (iii) any business concern that receives financial assistance from a SBIC.[4]

The Updated Affiliation Guidance mirrors many of the tests set forth in 13 CFR 121.301(f), but notably the Treasury’s Applicable Affiliation Rules fact sheet states in its opening sentence that there are “[f]our tests for affiliation”, thus implicitly excluding the other potentially important tests currently residing in 13 CFR 121.301(f) alongside the four identified tests.[5] The first test determines affiliation based on equity ownership: a PPP applicant is an affiliate of an individual, concern or entity that owns or has the power to control more than 50% of the business’s voting equity. The first test also states that the SBA will “deem a minority shareholder to be in control, if that individual or entity has the ability, under the concern’s charter, by-laws, or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.”[6] The second test describes circumstances under which the power to control, and therefore affiliation, will be deemed to exist or to not exist in connection with options, convertible securities, and agreements to merge.[7] The third test determines affiliation based on management, which in part states that affiliation “also arises where a single individual, concern or entity controls the management of the applicant concern through a management agreement.”[8] Lastly, the fourth test determines affiliation based on identity of interest, and stipulates that affiliation arises between close relatives (as defined in 13 CFR 121.10) with identical or substantially identical business or economic interests.[9] The Updated Affiliation Guidance confirms that, as with any other SBA Business Loan Program, any single test can be determinative of the existence of affiliation for a PPP applicant.

Highlights of our analysis of the Updated Affiliation Guidance are as follows:

1. As indicated above, there are no changes to the rules determining affiliation of a holder of 50% or more of a PPP applicant’s voting equity—such holder (g., a private equity buyout fund) is conclusively an affiliate of the applicant.

2. The Updated Affiliation Guidance simplifies our analysis for determining affiliation for equity holders owning less than 50% of the PPP applicant’s voting equity. Our view is that a minority investor (g., a venture capital fund) is more likely to not be treated as an affiliate of a PPP applicant under traditional venture capital structures, but as noted above, under the first test of affiliation the SBA will deem a minority investor to be in control if such investor has the ability, under the PPP applicant’s charter, by-laws, or shareholder’s agreement to prevent a quorum or otherwise block action by the board of directors or shareholders.[10]

3. The Updated Affiliation Guidance may make certain healthcare organizations operating under “friendly physician” models eligible for the PPP by reducing the likelihood of treating the practice entity (PC) and management services organization (MSO) as affiliates of each other.[11]

4. There is a new religious exemption to the affiliation rules. The Treasury’s Applicable Affiliation Rules fact sheet states that “the relationship of a faith-based organization to another organization is not considered an affiliation with the other organization if the relationship is based on a religious teaching or belief or otherwise constitutes a part of the exercise of religion.” The SBA’s Second Interim Final Rule provides its reasoning for exempting faith-based organizations from the SBA’s affiliation rules and amends the text of 13 CFR 121.103(b) to account for the religious exemption.

At this time we are not aware of any additional or forthcoming guidance or waivers to the application of the affiliation rules, and we believe that the Updated Affiliation Guidance satisfies the SBA’s statement in their First Interim Final Rule that they intend to “promptly” issue additional guidance with regard to the applicability of affiliation rules under existing federal regulations. The Updated Affiliation Guidance does not, however, preclude the issuance of additional guidelines or waivers or suggest that the Updated Affiliation Guidance is the final word on rules of affiliation.

FOOTNOTES

[1] The SBA’s Second Interim Final Rule is effective without advance notice and public comment because Section 1114 of the CARES Act authorizes the SBA to issue regulations to implement Title 1 of the Cares Act without regard to notice requirements.
[2] Prior to the Updated Affiliation Guidance, the basis for this view was as follows: Pursuant to 13 CFR 120, the SBA’s “Business Loan Program” (as referenced in 13 CFR 121.103(a)(8)) includes the SBA’s financial assistance to businesses authorized under Section 7(A) of the Small Business Act. The CARES Act established the PPP by way of an amendment to Section 7(A) of the Small Business Act, thereby making the PPP a Business Loan Program. 13 CFR 121.103(a)(8) expressly provides that the affiliation rules for an applicant under any Business Loan Program of the SBA is set forth in 13 CFR 121.301.  Consistent with the foregoing, and as noted in the Updated Affiliation Guidance, the citations to 13 CFR 121.103 in the CARES Act with respect to affiliation is a drafting error.
[3] We note that the Updated Affiliation Guidance does not modify, or even clarify, the glaring distinction between (i) the extension of eligibility to NAICS “72” business concerns having not more than 500 employees per physical location, and (ii) the waiver of the application of affiliation rules for NAICS “72” business concerns having not more than 500 employees. Our analyses of the application of these rules under various scenarios suggests this may be intentional, and would be consistent with the SBA’s continuing reluctance to relax the affiliation rules for business concerns having an owner that holds a majority of its equity interests.
[4] The CARES Act only (and erroneously) waives the affiliation rules prescribed by 13 CFR 121.103 for the same circumstances.
[5] The following affiliation tests under 13 CFR 121.301(f) were excluded (presumably intentionally):

• 13 CFR 121.301(f)(4)(i): Affiliation based on identity of interest – general. Affiliation may arise among two or more individuals or firms with an identity of interest. Individuals or firms that have identical or substantially identical business or economic interests (such as close relatives, individuals or firms with common investments, or firms that are economically dependent through contractual or other relationships) may be treated as one party with such interests aggregated. Where SBA determines that such interests should be aggregated, an individual or firm may rebut that determination with evidence showing that the interests deemed to be one are in fact separate.

• 13 CFR 121.301(f)(4)(iii): Affiliation based on common investments. Affiliation arises through common investments where the same individuals or firms together own a substantial portion of multiple concerns in the same or related industry, and such concerns conduct business with each other, or share resources, equipment, locations, or employees with one another, or provide loan guaranties or other financial or managerial support to each other. However, where an SBA Lender has made a determination of no affiliation under this ground, SBA will not overturn that determination as long as it was reasonable when made given the information available to the SBA Lender at the time.

• 13 CFR 121.301(f)(4)(iv): Affiliation based on economic dependence. Affiliation based upon economic dependence may arise when a concern derived more than 85 percent of its receipts over the previous three fiscal years from a contractual relationship with another concern, unless: (A) The contract (or contracts) does not restrict the concern in question from selling the same type of products or services to another purchaser; or (B) SBA agrees that the terms of the contract (or contracts) do not provide the purchaser with control or the power to control the seller.

• 13 CFR 121.301(f)(5): Affiliation based on new organized concern rule under this paragraph. Affiliation may arise where current or former officers, directors, owners of a 20 percent interest or greater, managing members, or persons hired to manage day-to-day operations of one concern organize a new concern in the same or related industry or field of operation, and serve as the new concern’s officers, directors, owners of a 20 percent interest or greater, or managing members, and there are direct monetary benefits flowing from the new concern to the original concern. A concern may rebut such an affiliation determination by demonstrating a clear line of fracture between the two concerns. A concern will be considered “new” for the purpose of this paragraph (f)(5) if it has been actively operating for two years or less. However, where an SBA Lender has made a determination of no affiliation under this ground, SBA will not overturn that determination as long as it was reasonable when made given the information available to the SBA Lender at the time.

• 13 CFR 121.301(f)(6): Affiliation based on the totality of the circumstances.In determining whether affiliation exists, the SBA may consider all connections between the concern and a possible affiliate. Even though no single factor is sufficient to constitute affiliation, SBA may find affiliation on a case-by-case basis where there is clear and convincing evidence based on the totality of the circumstances. However, where an SBA Lender has made a determination of no affiliation, SBA will not overturn that determination as long as it was reasonable when made given the information available to the SBA Lender at the time.

• 13 CFR 121.301(f)(7): Affiliation based on franchise agreements. (i) The restraints imposed on a franchisee by its franchise agreement generally will not be considered in determining whether the franchisor is affiliated with an applicant franchisee provided the applicant franchisee has the right to profit from its efforts and bears the risk of loss commensurate with ownership. SBA will only consider the franchise agreements of the applicant concern. SBA will maintain a centralized list of franchise and other similar agreements that are eligible for SBA financial assistance, which will identify any additional documentation necessary to resolve any eligibility or affiliation issues between the franchisor and the small business applicant; and (ii) For purposes of this section, “franchise” means any continuing commercial relationship or arrangement, whatever it may be called, that meets the Federal Trade Commission definition of “franchise” in 16 CFR part 436.

[6] This test is identical to the test residing at 13 CFR 121.301(f)(1).
[7] This test is identical to the test residing at 13 CFR 121.301(f)(2).
[8] This test is identical to the test residing at 13 CFR 121.301(f)(3). The Updated Affiliation Guidance provides no further guidance on what is intended by “controls the management of the concern,” and we believe published decisions by the SBA’s Office of Hearings and Appeals still have value as sources of additional guidance.
[9] This test is nearly identical to the test residing at 13 CFR 121.301(f)(4)(ii).
[10] Affiliation rules under 13 CFR 121.103 are expressly broad, and their application readily ensnares many minority investors into the blackhole of affiliation. In particular, while 13 CFR 121.301 mirrors many rules of 13 CFR 121.103, it purposefully omits the following rules of 13 CFR 121.103: (a) “SBA considers factors such as ownership, management, previous relationships with or ties to another concern, and contractual relationships, in determining whether affiliation exists.” 13 CFR 121.103(a)(2); (b) “Control may be affirmative or negative. Negative control includes, but is not limited to, instances where a minority shareholder has the ability, under the concern’s charter, by-laws, or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.” 13 CFR 121.103(a)(3) [emphasis added]; (c) “If two or more persons (including any individual, concern or other entity) each owns, controls, or has the power to control less than 50 percent of a concern’s voting stock, and such minority holdings are equal or approximately equal in size, and the aggregate of these minority holdings is large as compared with any other stock holding, SBA presumes that each such person controls or has the power to control the concern whose size is at issue.” 13 CFR 121.103(c)(2) [emphasis added]. Importantly, we note that the Updated Affiliation Guidance disposes of the “totality of the circumstances” test contained in both 13 CFR 121.103(a)(5) and 13 CFR 121.301(f)(6), which would otherwise permit the SBA to scrutinize the purported non-existence of an affiliation by considering “all connections” between the business concern and the possible affiliate, and could cause a determination of affiliation based on multiple factors even though no single factor on its own is sufficient to constitute affiliation.
[11] We note that the following rule under 13 CFR 121.103, which no longer applies, would otherwise by itself implicate a finding of affiliation between a PC and MSO: “Affiliation based on identity of interest. Affiliation may arise among two or more persons with an identity of interest. Individuals or firms that have identical or substantially identical business or economic interests (such as family members, individuals or firms with common investments, or firms that are economically dependent through contractual or other relationships) may be treated as one party with such interests aggregated.” 13 CFR 121.103(f) [emphasis added]. Careful analysis of all contractual arrangements is still required to determine whether affiliation exists. In particular, we note that many “friendly physician” models include equity transfer agreements or other contractual mechanisms permitting, among other things, the MSO to effectively replace the owners of the PC. This may provide the MSO with control over management of the PC, which the Updated Affiliation Guidance unambiguously states would constitute an affiliation.