The Paycheck Protection Program (PPP), which is one of the financial assistance programs included in the Coronavirus Aid, Relief and Economic Security Act (the CARES Act), offers low interest and forgivable loans to small businesses to cover certain eligible costs. Eligibility for PPP loans is based primarily on the borrower having 500 or fewer full- and part-time employees, or on the business qualifying as a small business under the SBA's existing employee-based and revenue-based size standard for the industry that the small business operates in. PPP is administered by the U.S. Small Business Administration (SBA) as a new product to its existing loan program. A detailed summary of the PPP is available here.

Qualifying for PPP Loans—the "Affiliate" Problem

The attractive features of the PPP loans have drawn applications from many small businesses, but small businesses with institutional investors that otherwise would be qualified for the PPP loans have found themselves unable to access the PPP loans due to the SBA's existing "affiliation" rules requiring the aggregation of the employees of companies that are under common "control" for the purposes of the employee-based size standard (the same goes for the revenue based sized standard). As discussed here, the affiliation rules under the Small Business Act define "control" to include both "affirmative control" (i.e., greater than 50% of equity ownership or control of a majority of the board seats) and "negative control", which exists where a minority shareholder "has the ability, under the concern's charter, by-laws, or shareholders' agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders." As a result, portfolio companies, in which institutional investors, such as private equity sponsors, venture capital funds, corporate investors, private family offices and other investment firms or institutional investors, have veto rights, minority board seats and other contractually agreed oversight roles may not be eligible to participate in the PPP. Consequently, many portfolio companies wishing to take advantage of the PPP loans have sent requests to their institutional investors for broad waivers of any rights such investors have under the shareholder agreements or governance documents to the extent necessary to permit such portfolio companies to qualify for the PPP loans.

Important Considerations for Investors

Institutional investors may not have a great deal of time to consider how to respond to waiver requests from their portfolio companies—at the point of sending a request, the company may already be in urgent need for additional liquidity. In the absence of additional guidance from the SBA relaxing the affiliation rules for the purpose of allowing a greater number of companies to access PPP, institutional investors should start actively considering what steps, if any, they will be willing to take in order to allow a portfolio company to qualify for the PPP funding.

Factors to consider with respect to each portfolio company:

• which existing rights will need to be waived to avoid application of the affiliation rules
• the company's current liquidity situation
• availability of other funding sources

Which rights trigger the affiliation problem?

An institutional investor should resist a request for an overbroad waiver of rights from a portfolio company. Such a broad waiver is likely unnecessary and not in the investor's best interest. While the affiliation rules do not include an express list of the types of rights that would constitute "negative control", SBA's Office of Hearings and Appeals has considered this issue in other contexts, and its decisions offer helpful guidelines as to which rights are likely found to trip the affiliation test and which ones are likely not. As a general matter, veto rights over day-to-day operational decisions of a company such as the following are likely to be found to constitute "negative control" over the company:

• dividends
• budget
• business plan
• capex
• personnel
• business strategies
• ordinary course incurrences of debt or entry into commercial contracts

Veto rights over fundamental or extraordinary matters that are aimed at protecting an investor's investment such as the following are likely to be found not to constitute negative control:

• sale of all or substantially all of the assets
• mergers and acquisitions
• change in line of business
• bankruptcy
• amendment of organizational documents

Therefore, an investor should consider taking a more surgical approach if it receives an overbroad waiver request. Investment committee decisions with respect to minority investments are not made lightly in the first place, and the negative control rights institutional investors obtain are often critical to a decision to invest. Analyses of future performance of a portfolio company may depend in part on the level of control an institutional investor can exert. In a market currently defined by uncertainty and fluctuation of valuations, an institutional investor may well prefer not to waive any of its rights, even at the expense of the liquidity need of its portfolio company.

Must any waiver be permanent?

Another issue to consider in the context of a waiver is whether the waiver can be limited in time. The Treasury clarified that an "irrevocable" waiver or relinquishment by an investor of the rights that would otherwise constitute control in a company would result in the company ceasing to be considered an affiliate of the investor for the purpose of the employee-based size threshold. However, it has not clarified what an "irrevocable" waiver means and to date we have not located analogous precedent in this space that would suggest that it means anything other than "permanent." Guidance in the market from law firms and advisors appears to be coalescing around that conclusion, although there could certainly be a reasonable basis to conclude that "irrevocable" should apply only to the period prior to the repayment, maturity or forgiveness of the loan. The potential permanency of the waiver provides another reason for the investor to be careful about the waiver decision.

Are there alternatives to a waiver?

In some cases, investors may consider amendment of the shareholder agreements or organizational documents as a preferable alternative to a waiver. In addition to amending or removing certain veto rights that may constitute "negative control," an amendment could enable an investor to build in additional protections for its investment in exchange for giving up such veto rights, such as protection against down-round financing or a "make whole" in the case of a near term liquidity event. The presence of such additional protective provisions may provide an incentive for the portfolio company to re-amend the shareholder agreements or organizational documents to remove such additional provisions and restore the veto rights once the PPP loan is paid off or forgiven. Of course, the amendment approach does not come without drawbacks, as it will likely involve negotiation with multiple investors, whose interests may or may not align. It also may take much longer to negotiate an amendment than a simple waiver, and the portfolio company may lose the window of availability of a PPP loan since it is disbursed on a first come first serve basis. Accordingly, an investor should evaluate which approach to take on a case by case basis based on the totality of the circumstances.

There are significant lobbying activities currently underway in this area and it is possible that SBA will issue additional clarification on the applicability of the affiliation rules in the context of the PPP in the near future. We are monitoring the situation closely and will update our recommendations once new guidance on this topic is issued.

Andrea Basham is a Corporate and M&A Counsel at Freshfields Bruckhaus Deringer whose practice focuses on disclosure and ongoing reporting obligations of public companies, public and private offerings of securities in the United States and elsewhere, and securities law and reporting aspects of M&A transactions involving public companies. She also advises companies and shareholders on their equity investments, including corporate venture capital programs.

Zheng (Jonathan) Zhou is a Corporate and M&A Counsel at Freshfields Bruckhaus Deringer whose practice focuses on complex domestic and cross-border M&A and other corporate and financial transactions. He has led numerous M&A projects, including acquisitions and sales of private companies, high profile sales and acquisitions of publicly traded companies, investments by private equity and sovereign wealth funds, carve-out divestitures by publicly traded companies, and joint ventures and other strategic partnerships.