This is a sequel to the popular articles: “COVID-19 Crash Course for Small Biz Payroll Protection Plan Applicants,” “A Quick, Easy Update on the CARES Act,” “CARES Act Potholes,” “The Big CARES Act Double Dip,” “How to Borrow CARES Act Money and Legally Not Pay It Back,” and “Who Got CARES Act Loans and How Much“
EDITED BY GEORGE W. HIGHTOWER
In forecasting what’s coming next regarding the federal government’s Paycheck Protection Program (PPP), it is important to understand the lending environment. We thought it might be helpful to look at the lender’s role, why there may have been so much lender confusion at the inception of the program, and how the lenders actually get paid back.
For those with PPP loans, this may also foretell some of what may come to pass when the forgiveness cycle kicks into gear. Bear in mind our overriding and oft-repeated rule #1: only trust information from a dot-gov website.
The start line
The Cares Act was signed into law by President Donald Trump on Friday, March 27, 2020. The SBA began accepting PPP loan applications—a keystone of the law—on Friday April 3, 2020. Lenders scrambled to understand the program’s 880 pages, while establishing policies on the fly that managed the processing, review, and approval of loan applications. Banks were faced with a new paradigm of lending and in many cases were uncertain about how to proceed. Their caution, once you understand their perspective, was understandable.
The three Cs of lending
Typically, a lender looks toward the three Cs of lending—character, capacity, and collateral—to determine how exactly you will repay a loan. Character is often measured as to whether the borrower pays its bills on time (FICO scores and similar business credit ratings through organizations like Dun & Bradstreet and PayNet). Capacity is often judged by the tedious task of analyzing financial statements to determine whether the business has adequate profits and cash flow to repay the loan. While collateral is an analysis of the assets pledged to secure the loan, which assures there is adequate backup value in the event that a borrower defaults.
For a PPP loan, the Cs don’t play any role in the initial assessment: “In evaluating the eligibility of a borrower for a covered loan…a lender shall consider whether the borrower…was in operation on February 15, 2020; and…had employees for whom the borrower paid salaries and payroll taxes; or…paid independent contractors, as reported on a Form 1099–MISC.”
It gets better. A few paragraphs later, the text reveals that “During the covered period, with respect to a covered loan…no personal guarantee shall be required for the covered loan; and…no collateral shall be required for the covered loan.”
Lenders were understandably confused as to how to approve PPP loan requests. A banker is the archetype of conservative and cautious, long taught to look at the three Cs. That left them scratching their heads as to what they should evaluate. It would be blasphemy to assume the program would simply grant money to anyone who asks politely for it.
Whose money is it anyway?
Most people believe the PPP loan is funded by the government—it isn’t, at least not in the beginning. When you receive funding for a PPP loan, you are receiving the bank’s money, not the government’s. Banks are careful about their treasure chests—money entrusted to them by depositors and watched over by regulators. The government doesn’t immediately transfer the money for this program into local hands. Instead, the US Small Business Administration (SBA) provides the bank a guarantee. The program assumes that in the worst case for the government, all the loans will be forgiven. Hence, the hard cap on the amount of guarantees available.
The Great Recession of December 2007 through June 2009 was triggered by the bursting of the housing bubble. That bubble was inflated, in large part, by mortgage loans that required no supporting evidence of a borrower’s income. Instead, the loans were granted based on a declaration confirming the borrower “can afford” the loan payments. Borrowers in need of money were very willing to lie on the declarations and these became known as liar loans.
The bursting of the housing bubble, of course, brought banks to their knees, begging for government bailouts. The old adage “once bitten, twice shy” became ingrained in lenders. Hence, until lenders received clear guidance from the feds about how to process PPP loans, one can understand why they were reluctant to move forward.
Just take the money
To help clear up program confusion and address lender apprehension, the SBA issued Frequently Asked Questions and a first draft of their PPP Interim Final Rule. SBA guidance required lenders to “confirm the dollar amount of average monthly payroll costs for the preceding calendar year by reviewing the payroll documentation submitted with the borrower’s application.” Notably, lenders were not required to replicate a borrower’s calculations:
Providing an accurate calculation of payroll costs is the responsibility of the borrower, and the borrower attests to the accuracy of those calculations on the Borrower Application Form. Lenders are expected to perform a good faith review, in a reasonable time, of the borrower’s calculations and supporting documents concerning average monthly payroll cost. For example, minimal review of calculations based on a payroll report by a recognized third-party payroll processor would be reasonable. In addition, as the PPP Interim Final Rule indicates, lenders may rely on borrower representations, including with respect to amounts required to be excluded from payroll costs.
Once the lenders became comfortable ditching their finely-tuned evaluation principles, all that was left to do was conduct a cursory review, confirm the identity of the business and the owners, approve the loan, and submit it to the SBA for their issuance of a guarantee. The critical component is the SBA guarantee; no guarantee, no loan. Banks ended up approving many more loans than the SBA was able to guarantee, but only the loans that the SBA guaranteed received an official confirmation from the lender.
The SBA guarantee
What the SBA provides is essentially a two-part guarantee that serves as the collateral for the local bank’s money that funds these loans.
1 – A guarantee of forgiveness. Whatever part of the loan used appropriately by a small business and is therefore forgiven, the SBA will cover, plus interest.
2 – A guarantee that the borrower will repay the unforgiven portion. If there is a default on the payback, the SBA covers the balance due.
How will banks get repaid?
From the date the borrower receives the loan, they have eight weeks to spend the funds on forgivable expense items: at least 75% of the amount spent for payroll and benefits, while no more than 25% can cover rent or mortgage interest and utilities. Some time at the end of that period, the borrower will submit their forgiveness calculations and supporting documentation to the lender requesting the loan be forgiven.
The SBA has not issued guidance on forgiveness, and there are two schools of thought—extreme leniency on one hand, or diligent and careful review on the other. More on this topic in the next installment of this series, but here’s what the fine print says:
Not later than 60 days after the date on which a lender receives an application for loan forgiveness under this section from an eligible recipient, the lender shall issue a decision on the an [sic] application.
Once the decision is issued, the lender submits a request for the SBA to pay up on their guarantee of the forgiveness.
Not later than 90 days after the date on which the amount of forgiveness under this section is determined, the Administrator shall remit to the lender an amount equal to the amount of forgiveness, plus any interest accrued through the date of payment.
Assuming a borrower is honest and diligent, banks should have their money back in hand in approximately seven months. Interest is set at 1% per year. That’s a low rate for a commercial loan, but the government’s reasoning is that a two-year treasury bill pays about 0.23% per year, and since the government is guaranteeing these loans, the 77 basis point spread is a fair premium, especially when one considers the fees banks receive to administer the loans (5% on loans to $350K, 2% on loans to $2 million, and 1% on loans to $10 million).
What about amounts not forgiven?
Leftover balance from the loans that do not meet the criteria for forgiveness are subject to a six-month deferral followed by 18 months of repayment. The six months starts on the date the loan is issued. That means six months after a borrower receives their PPP funds, any amount not forgiven is repaid over 18 months. That’s a relatively short term, and payments will be quite high in relation to the balance to be repaid. However, the plan is designed for minimal balances to remain after forgiveness.
What else can I use PPP funds to pay for?
Aside from payroll, benefits, rent, utilities, or mortgage interest—nothing! No exceptions. Not even for legal fees to defend you from fraud charges.
The CARES Act has a specific subsection entitled “Allowable Uses Of Covered Loans” that provides that “an eligible recipient may, in addition to the allowable uses of a loan made under this subsection, use the proceeds of the covered loan for” a set list of expenses including payroll costs, employee benefits, interest payments on a mortgage obligation, rent, utilities, or other interest. We suggest you click “(F) Allowable Uses Of Covered Loans” and read the actual text, as it is a bit longer than what we summarize here.
Watch where you spend it
The act states the borrower is required to certify that the “funds will be used to retain workers and maintain payroll or make mortgage payments, lease payments, and utility payments.” From here, it might be easiest to simply cut to some direct quotes from the SBA’s PPP Federal Interim Rule [emphasis added]:
What happens if PPP loan funds are misused?
- If you use PPP funds for unauthorized purposes, SBA will direct you to repay those amounts. If you knowingly use the funds for unauthorized purposes, you will be subject to additional liability such as charges for fraud. If one of your shareholders, members, or partners uses PPP funds for unauthorized purposes, SBA will have recourse against the shareholder, member, or partner for the unauthorized use.
What certifications need to be made?
- On the Paycheck Protection Program application, an authorized representative of the applicant must certify in good faith to all of the below: The funds will be used to retain workers and maintain payroll or make mortgage interest payments, lease payments, and utility payments; I understand that if the funds are knowingly used for unauthorized purposes, the Federal Government may hold me legally liable such as for charges of fraud. As explained above, not more than 25 percent of loan proceeds may be used for non-payroll costs.
- I further certify that the information provided in this application and the information provided in all supporting documents and forms is true and accurate in all material respects. I understand that knowingly making a false statement to obtain a guaranteed loan from SBA is punishable under the law, including under 18 U.S.C. 1001 and 3571 by imprisonment of not more than five years and/or a fine of up to $250,000; under 15 U.S.C. 645 by imprisonment of not more than two years and/or a fine of not more than $5,000; and, if submitted to a federally insured institution, under 18 U.S.C. 1014 by imprisonment of not more than thirty years and/or a fine of not more than $1,000,000.
What this all seems to suggest is that you cannot use PPP funds for any purpose that might contribute to relaunching your business. Hence, if you’re a restaurant that chose to donate most of its food on hand and you hope to use PPP funds to restock when you re-open, think again. If you plan to use the money for marketing to drive customers back into your shop, that could be risky business. If you have suppliers that won’t drop off a new batch unless you pay down the existing balance, don’t use PPP funds. The SBA program is pretty explicit as to where the money can go.
How much of unforgiven loans should be left on the table?
Very little. As long as the anticipated payroll is paid and the headcount is restored, most of the loan should be forgiven. If a substantial amount is not forgiven, it could become a red flag for a review or audit. For example, if for some reason a borrower can’t use all the funds—your business is closed down for several weeks into the eight-week period—there should be plenty of money left in your account because you are prohibited from spending the funds on other purposes. No one is thinking about fraud now, but give it time to ripen. Like all government programs that had to be rushed through, eventually someone within will audit the results. That will happen in calmer times, when the economy is recovering, and excuses might not play so well.
Stay tuned for our upcoming installment. In the meantime, for a better understanding of forgiveness, check out How to Borrow CARES Act Money and Legally Not Pay it Back.