CARES Act: Small Business Loan Eligibility & “Affiliation” Issues Explained

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As we discussed in a previous article, the Coronavirus Aid, Relief, and Economic Security Act, known as the “CARES Act,” provides much-needed relief to “small” businesses in several areas, including by appropriating substantial money to support the 7(a) Loan Program and the Economic Injury Disaster Loan (EIDL) Program.

However, determining whether one’s business is, in fact, an eligible “small” business has already proven to be confusing and complicated, even for sophisticated applicants. Even more perplexing to many is the question of whether a business is legally “affiliated” with another business, such that the businesses will be viewed together for loan eligibility purposes and, when combined, may not be considered an eligible “small” business.

This article, accordingly, aims to provide a user-friendly guide on these threshold small business loan program eligibility issues.

1. General

7(a) Loan Program

The following concerns are eligible under the CARES Act for the 7(a) Loan Program: (1) small business concerns, nonprofit organizations, veterans’ organizations, and tribal business concerns in each case with 500 or fewer employees; (2) business concerns that already met the applicable size standard for their industry as provided by the normal Small Business Administration (SBA) rules, if those rules permitted a small business to have more than 500 employees, or if the business qualified as small based on a revenue-based size standard; (3) sole proprietors, independent contractors, and other self-employed individuals; and (4) business concerns in the Accommodation and Food Service industries with more than one physical location so long as that business concern does not have more than 500 employees per physical location.

EIDL Program

The following concerns are eligible under the CARES Act for the EIDL Program: (1) business concerns with not more than 500 employees; (2) small business concerns that already met the applicable size standard for the industry as provided by the SBA, if the number of employees is greater than 500; (3) private nonprofit organizations; (4) small agricultural cooperatives; (5) any individual who operates under a sole proprietorship or as an independent contractor; (6) a cooperative with not more than 500 employees; (7) an employee stock ownership plan (ESOP) with not more than 500 employees; and (8) tribal small business concerns with not more than 500 employees.

What Is “Affiliation”?

While the foregoing criteria for both programs may seem straightforward, as noted above, the question of whether a business is, in fact, “small” has proven to be complicated and confusing even for sophisticated applicants. This is primarily because of the so-called “affiliation” rules that are set forth in the SBA’s regulations. Under the SBA’s regulations, if an entity is determined to be an “affiliate” of another entity, the SBA will combine the employees/annual receipts of the entities to determine whether the applicant entity is “small.”

Section 1102 (Paycheck Protection Program) of the CARES Act references the SBA’s existing general “affiliation” regulations (13 C.F.R. § 121.103). Subsection (a)(8) of the SBA’s general “affiliation” regulations, in turn, states: “For applications in SBA’s Business Loan, Disaster Loan, and Surety Bond Guarantee Programs, the size standards and bases for affiliation are set forth in [13 C.F.R.] § 121.301.”

Subsection (f) of 13 C.F.R. § 121.301, in turn, addresses “affiliation” issues in the context of SBA loan programs, such as the 7(a) Loan Program and the EIDL Program, stating: “Concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists.”

2. Affiliation Rules

The SBA’s regulations state that “[a]ffiliation under any of the circumstances described below is sufficient to establish affiliation” for an applicant of these loan programs.

Affiliation Based on Ownership

  • For determining affiliation based on equity ownership, a concern is an affiliate of an individual, concern, or entity that owns or has the power to control more than 50% of the concern’s voting equity.
  • If no individual, concern, or entity is found to be in control, SBA will deem the board of directors or president or chief executive officer (CEO) (or other officers, managing members, or partners who control the management of the concern) to be in control of the concern.
  • SBA will deem a minority shareholder to be in control if that individual or entity has the ability, under the concern’s charter, bylaws, or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.

Affiliation Arising under Stock Options, Convertible Securities, and Agreements to Merge

  • In determining size, SBA considers stock options, convertible securities, and agreements to merge (including agreements in principle) to have a present effect on the power to control a concern. SBA treats such options, convertible securities, and agreements as though the rights granted have been exercised.
  • Agreements to open or continue negotiations towards the possibility of a merger or a sale of stock at some later date are not considered “agreements in principle” and are thus not given present effect.
  • Options, convertible securities, and agreements that are subject to conditions precedent which are incapable of fulfillment, speculative, conjectural, or unenforceable under state or Federal law, or where the probability of the transaction (or exercise of the rights) occurring is shown to be extremely remote, are not given present effect.
  • An individual, concern or other entity that controls one or more other concerns cannot use options, convertible securities, or agreements to appear to terminate such control before actually doing so. SBA will not give present effect to individuals’, concerns’, or other entities’ ability to divest all or part of their ownership interest in order to avoid a finding of affiliation.

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.
  • Affiliation also 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 of more other concerns.
  • Affiliation also arises where a single individual, concern or entity controls the management of the applicant concern through a management agreement.

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.

Close Relatives

Affiliation arises when there is an “identity of interest” between close relatives, with identical or substantially identical business or economic interests (such as where the close relatives operate concerns in the same or similar industry in the same geographic area).

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, 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 these grounds, 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.

Economic Dependence

Affiliation based upon economic dependence may arise when a concern derived more than 85% 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.

Affiliation Based on the Newly Organized Concern Rule

  • Affiliation may arise where current or former officers, directors, owners of a 20% 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% 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” if it has been actively operating for two years or less. However, where an SBA lender has made a determination of no affiliation under these grounds, 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.

Affiliation Based on Totality of the Circumstances

  • Importantly, in determining whether affiliation exists, 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.

3. Exceptions to Affiliation

The CARES Act provides exceptions to the “affiliation” rules for:

  • Business concerns in the Accommodation and Food Services industries with not more than 500 employees;
  • Franchises that are approved on the SBA’s Franchise Directory; and
  • Small business concerns that receive financial assistance from a Small Business Investment Company.

The CARES Act, moreover, did not repeal the existing exceptions to the affiliation rules, which are referenced at 13 C.F.R. § 121.301(9) and located at 13 C.F.R. 121.103(b).

4. Conclusion

Determining whether one’s business is, in fact, an eligible “small” business – or rather, is legally “affiliated” with another business such that the applicant may not actually be an eligible “small” business – has understandably proven to be a complicated and confusing task for many potential loan applicants. It is our hope that the above guide makes this important task less confusing and intimidating for small business loan applicants.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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