How Loans Can Impact Size and Status

by PilieroMazza PLLC
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PilieroMazza PLLC

It’s protest season. Or, maybe it is always protest season. In any event, the best defense for a size or status protest is always to be prepared before the protest is filed. That means regularly assessing potential affiliations that could affect your size and status.    

With that in mind, I want to share some information about how affiliation can arise through loans. Specifically, loans from a private party (i.e., an individual or a company, not a bank). SBA will generally look more favorably on the terms of a loan when the party loaning the money is a traditional lender like a bank. But, when the source of the funds is not a traditional lender, you have to be more careful to ensure the loan does not create an affiliation between the lender and the lendee.

The existence of a loan from a private party, in-and-of-itself, should not give rise to affiliation. Affiliation is always about control – does one party have the ability to control the other. So, the key in assessing the potential for affiliation based on a loan from a private party is the terms of the loan. If the note contains customary, arms-length terms that do not give the lender the power to control the lendee (absent an event of default), the loan by itself should not cause an affiliation. SBA case law confirms that when parties enter into a legally-binding loan agreement, and the terms of the note do not allow the lender the ability to exert control over the lendee, the note does not create affiliation. The view of these cases is that any leverage the lender could have exerted over the lendee ended when the parties entered into a written and signed agreement to document the terms of the loan; once the note is signed, the note defines the parties’ relationship. Therefore, it is important to ensure the terms of the note are in writing, binding, customary, and do not give the lender the power to control except for typical rights in the event of default.

SBA will question a loan from a private party that shows a lack of normal business practices. In these cases, SBA has found that a significant loan from a private party created affiliation, especially when the terms of the loan are either unclear or not in writing, when the amount of the loan is much larger than the firm’s revenues, and when the lendee has not been repaying the loan. Factors like these indicate the loan was not commercially reasonable or an arms-length transaction, which will cause SBA to question the legitimacy of the arrangement and infer the lender’s ability to control through the loan.

The purpose of the loan is also important in the affiliation analysis. Generally speaking, there is a greater risk of affiliation if the loan provides the lendee with ongoing financial assistance that it depends on to continue operating its business. By contrast, the risk of affiliation is lessened if the loan is a one-time financial transaction, such as for the acquisition of stock, and if the written terms of the note make clear that any ability the lender had to exert control ceased when the transaction was finalized.

These are just a few of the affiliation considerations when seeking or making a loan from a private party. There are many factors at play and the affiliation analysis almost always depends on the unique facts and circumstances of the case and relationship between the parties. 

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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