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Suggested Modeling Principles to Support the PPP Necessity Certification

Greg Halm

September 16, 2020

The Actual Impact of COVID and PPP Proceeds

To apply for and obtain a loan under the Paycheck Protection Program (PPP), applicants needed to certify that “[c]urrent economic uncertainty makes this loan necessary to support the ongoing operations of the Applicant.” This is known as the Necessity Certification. There is hardly any constructive regulatory guidance as to how an applicant should support its Necessity Certification. Fortunately for many small businesses, Secretary Mnuchin and the Small Business Administration (SBA) have granted safe harbor to businesses that borrowed less than $2 million, in that the certification will have been deemed to have been made in good faith. However, Secretary Mnuchin and the SBA have vowed (or at least threatened) to review each loan in excess of $2 million for compliance with the Necessity Certification. Based on published data, 28,982 recipients received $2 million or more in PPP loans. Checking each would be a tall order.

This article suggests modeling approaches that are likely to satisfy regulatory scrutiny for businesses that borrowed $2 million or more, notwithstanding how little regulatory guidance exists.

Regulatory Guidance on the Necessity Certification 

The SBA provided a succinct statement about its understanding of the objective of PPP at inception of the program: “to provide [small business] with the support they need to remain open and keep their workers employed.”Presumably, this can mean that an applicant for PPP funds should believe that without the funds, it would either be unable to remain open or could only remain open to an extent by making reductions in its workforce.

After PPP was rolled out, Secretary Mnuchin and the SBA issued further limited guidance regarding the Necessity Certification. This limited guidance focuses on the liquidity of the business. On April 23, 2020, the SBA published an answer to its FAQ 31, which states in part: “Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. For example, it is unlikely that a public company with substantial market value and access to capital markets will be able to make the required certification in good faith.”

Consistent with the foregoing, an April 28, 2020, CNBC article quotes Secretary Mnuchin as saying, “This was a program designed for small businesses…It was not a program that was designed for public companies that had liquidity.” In another article published on April 28, 2020, Secretary Mnuchin is quoted as singling out a specific non-public business, the Los Angeles Lakers basketball team, as an entity that should not have applied for the program. He is quoted in Wall Street Journal article as saying, “I’m not a big fan of the fact that they took a $4.6 million loan… I think that’s outrageous, and I’m glad they’ve returned it, or they would have had liability.”

While this guidance far from clear, if unpacked it can be instructive regarding a business’s necessity for receiving a PPP loan. However, before evaluating potential modeling approaches that are consistent with this guidance, it is important to address a key enticing aspect of PPP: loan forgiveness.

Loan Forgiveness

From a literal reading of the CARES Act, to obtain forgiveness a recipient of a PPP loan need only show that it spent an amount at least equal to the forgiveness amount on eligible payroll expenses, mortgage interest payments for the business, rent or lease payments, and utility payments. Other provisions reduce the forgiveness amount if headcount or employee compensation is reduced. There is relatively specific guidance regarding the formula to be used in calculating the forgiveness amount, and several entities have developed tools to assist businesses with this calculation. For example, the AICPA provides a free MS Excel–based file to help businesses fill out the loan forgiveness application.

In light of the foregoing, nearly any eligible borrower that at least maintained its operations should be eligible for loan forgiveness if its PPP loan request was made in an amount designed to equal the amount of eligible expenditures. Businesses do not need to show, with the benefit of hindsight, that they actually needed PPP funds in order “to remain open and keep their workers employed.” In fact, there is no consideration in the forgiveness application as to whether the actual financial position of the business at the time of its application for forgiveness would allow it to repay PPP funds.

The relatively low bar for forgiveness (apart from the administrative efforts needed to support the forgiveness calculation) makes PPP enticing. Further, while PPP funds are given out initially as loans to be repaid, a recipient could reasonably assume that the loan would be forgiven when evaluating the prospective economics of the loan. However, as explained below, consideration of forgiveness in evaluating the necessity of a PPP loan is not likely to be prudent for a business looking to avoid regulatory scrutiny.

While Economically Rational, A Liquidity-Based Analysis That Assumes Loan Forgiveness Is Unlikely to Persuade

A business evaluating the Necessity Certification under the “significant detriment” standard in FAQ 31 could perform an analysis that projects its financial position if it obtains a PPP loan, and a similar projection under the assumption that it does not obtain the loan, assuming business operations are otherwise similar in each scenario. The difference between these two scenarios would show the impact on the financial position of the business if a PPP loan is not obtained, and would thus inform the “detriment” to the business of not obtaining a PPP loan.

In the scenario in which a PPP loan is obtained, the business would need to model the receipt of PPP funds as a positive cashflow and then model the repayment or lack thereof. In the scenario in which a PPP loan is not obtained, the business could obtain its liquidity from cash on hand, alternate borrowings and associated interest expense, or assume that no liquidity is obtained.

If the PPP loan is modeled as forgiven (an assumption that is indeed rational based on the plain text of the CARES Act), the non-PPP scenario cannot compete, simply because there is no competing with free revenue. For example, if the non-PPP scenario assumed the use of $2 million in cash on hand as an alternate to a $2 million forgiven PPP loan, the non-PPP scenario would be at least $2 million to the firm’s detriment, relative to the PPP scenario, even before consideration of the possible returns that could be achieved by investing the $2 million in cash. Most small businesses consider $2 million to be a significant amount of money.

Because this analysis does not depend on the size of a business, but rather the difference between two scenarios, the principles drawn from it would hold true for any “small business.” For example, even the Los Angeles Lakers, which apparently received (and returned) a $4.6 million PPP loan, could theoretically show a $4.6 million detriment associated with not obtaining a PPP loan so long as the team assumes loan forgiveness. Public companies could also make such a showing under the foregoing framework. Yet Secretary Mnuchin and SBA apparently believe that the Los Angeles Lakers and public companies would be extremely challenged to justify a Necessity Certification. Accordingly, the foregoing analysis, while rational and objective, would not be persuasive to regulators and is therefore not a prudent model.

Three Model Assumptions in a More Persuasive Liquidity-Based Model

A more persuasive liquidity-based model would employ three assumptions that are consistent with the limited guidance issued so far. The first assumption is that the PPP loan is a loan that will be repaid and is not free money. While the 1 percent interest rate, coupled with the absence of need to pledge collateral, gives a PPP loan much more-favorable terms than most loans that a business could obtain, treating it as a loan goes a long way toward leveling the playing field when comparing it to alternative sources of liquidity. For larger businesses with access to cash or other forms of financing, this assumption is likely to render the comparative difference between getting a PPP loan and not to be less material to the business as a whole.

The second assumption is that the PPP loan should not be used to repay existing financing that is not due or that could be refinanced with similar terms to the existing facility. Making this assumption ensures that there is actually a purpose for the PPP loan, apart from the low-hanging fruit of lower-interest expense.

The third assumption is that the PPP loan proceeds cannot be invested in short-term liquid investments with a yield in excess of 1 percent. This assumption ensures that the funds will be used for a business purpose, rather than for arbitrage purposes.

Businesses Should Look Beyond Liquidity to Model the Operational Impact of COVID 

The foregoing liquidity-based model could still show a significant benefit from a PPP loan, even for a public company (or the Los Angeles Lakers). For example, a business that is able to use the PPP funds to invest in operations and grow its business would show a significant benefit from a PPP loan, even as it satisfied the three model assumptions, and therefore would show a significant comparative detriment from not obtaining a PPP loan.

It is instructive to look at an inconsistency, perhaps unintentional, in Secretary Mnuchin’s public statements. On the one hand, he observes that public companies are likely not eligible for PPP; on the other hand, he encouraged significant funds to be directed toward multiple public companies in a program that, at a high level, is not that different from PPP. Specifically, the US government agreed to a $25 billion Payroll Support Program (PSP) to provide funding for airlines, many of which are large publicly traded companies with access to capital. At least one large airline that participated in PSP reported a relatively strong capital position as of July 31, 2020, with access to the capital markets and other credit. This company would fail a liquidity-only necessity test. However, like all airlines, this airline’s operations were abruptly decimated by COVID. Its second quarter 2020 revenue declined by more than 80 percent from the second quarter of 2019, causing it to swing from an operating profit to an operating loss even after accounting for direct payroll support funds.

While the airlines are not a perfect analogy, given that they were probably given favorable treatment by the US government for a strategic reason (i.e., to maintain an air travel system), it is instructive to look to the program to see how regulators can be persuaded that a company has a need for financial support. The airlines argued persuasively that they needed support because they were facing steep declines in revenue.

In light of the foregoing, a business should model not only its liquidity situation, but also the expected operational impact of COVID. For example, certain businesses were not impacted adversely from COVID, and certain businesses actually benefited from COVID. Therefore, even if a liquidity-focused model could show a detriment from not obtaining COVID funds—for example, if the funds could be invested to help grow the business—it would seem that this scenario may not be what Congress and the regulators have in mind as the target recipients of PPP loans.

Looking at the Actual Impact of COVID and PPP Proceeds Is a Good Idea

As noted above, the Necessity Certification is based on a supportable, forward-looking analysis at the time a business applies for a PPP loan. The application for forgiveness does not require a company to show in hindsight that it actually had a need. However, if a business can show in hindsight that it actually needed the PPP proceeds, it will have achieved a belt-and-suspenders approach to avoid scrutiny.

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Greg Halm

Managing Director

San Francisco Bay Area

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