As all financial institutions are beginning to realize, the rapidly evolving regulatory landscape surrounding the Paycheck Protection Program (“PPP”) is presenting several unintended consequences to both financial institutions and the general public. Many of these consequences have been well-documented and discussed by our colleagues at Nelson Mullins, yet another apparent consequence arises from the intersection of Regulation O and the PPP.

As financial institution regulatory compliance junkies know, Regulation O governs any extensions of credit by a financial institution to an executive officer, director, or principal shareholder of that financial institution, of its holding company, and of any other subsidiary of that holding company (all such persons, “Insiders”). Further, as particularly relevant to PPP loan programs, the regulation also applies to extensions of credit by a financial institution to a company “controlled” by the Insider.[1] The Regulation imposes several restrictions and prohibitions relating to:

• The types of loans which may be made to Insiders–
  • For example, loans must be made on substantially the same terms as loans to non-Insiders;
• Diligence and underwriting requirements–
  • For example, credit underwriting procedures must not be less stringent than those applicable to comparable transactions by the bank with non-Insiders;
• Reviewal and approval requirements–
  • For example, proper considerations must be given to executive/board reviewal and independence;
• Quantitative lending limits (on both an aggregate and individual basis)–
  • For example, these are generally tied to the percentage of the bank’s capital and surplus and other safety and soundness factors;
• Recordkeeping, reporting, and public disclosure requirements–
  • For example, maintaining appropriate documentation and disclosures for regulators and public stakeholders.

Suffice to say, for an institution to consider an extension of credit to an Insider or a company controlled by the Insider, the institution must scrutinize the loan for compliance with Regulation O.[2] Given this existing legal framework, it is very clear that Regulation O was not intended to prohibit altogether such extensions of credit, as a financial institution is generally permitted to lend to Insiders after it follows proper controls and processes.

With this background in mind, financial institutions are generally accustomed to evaluating potential Insider loans for Regulation O compliance requirements, and with the roll-out of the PPP many of these institutions were preparing to apply these same Regulation O standards to their PPP loan operations. However, with this particular PPP loan program, financial institutions should be aware that they are subject to additional Insider lending prohibitions.

In its recent Interim Final Rule implementing the PPP, the Small Business Administration (“SBA”) expressly notes that businesses which are identified in 13 C.F.R. § 120.110 are ineligible for PPP loans. Among the businesses listed, 13 C.F.R. § 120.110 provides that “businesses in which the Lender . . . or any of its Associates owns an equity interest” are generally ineligible. An “Associate” of a Lender is defined broadly to include:

(a) an officer, director, key employee, or holder of 20% or more of the value of the Lender’s stock or debt instruments, or an agent involved in the loan process; or

(b) any entity in which one or more individuals referred to in (a) or a close relative of any such individual owns or controls at least 20%.

Similarly, the SBA notes in its Standard Operating Procedures that it will “not guarantee a loan if the Lender, its Associates, partner(s) or a close relative: (i) Has a direct or indirect financial or other interest in the Applicant; or (ii) Had such interest within 6 months prior to the date of application.”

This guidance published by the SBA clearly challenges existing Regulation O standards. On the one hand, the federal government, through the federal banking regulators, appears to permit loans to Insiders that are compliant with Regulation O. Indeed, adding to the confusion, Regulation O specifically exempts from the aggregate lending limit restrictions loans that “are fully guaranteed as to principal and interest by the United States,”[3] which would be the case under the PPP loans. However, on the other hand, the government, through the SBA, appears to be taking the opposite position that even if a loan is compliant with Regulation O standards, the loan may not be eligible for the PPP loan guaranty. Many of our clients have already expressed some concern with this dual approach, and with this uncertainty in mind, we have generally advised them that the prudent course of action would be to avoid these PPP Insider loans as such loans would not be guaranteed. As the legal landscape continues to change, institutions should continue to be mindful of these restrictions and consult counsel as appropriate.