Asset Purchase Agreements and PPP Loans

Back in March 2020, Congress enacted the “CARES Act.” See news report here. The CARES Act was designed to ameliorate COVID-related economic hardships for individuals and businesses. One key component of the Act was the Paycheck Protection Plan (“PPP”). The PPP was intended to protect small businesses and their employees by providing loans through the Small Business Administration (“SBA”). PPP loans were limited to no more than $10 million and were only available for companies with fewer than 500 employees. If a PPP loan was used for eligible purposes, such as payroll-related costs, utilities and some other expenses, the loan was eligible for full or partial forgiveness.

Over the coming year or two, PPP loans should command heightened attention from those seeking to acquire or sell small businesses and should be a concern even if the transaction is structured as an asset purchase. Given the economic damage caused by the COVID-19 pandemic, we here at Revision Legal expect a significant number of small businesses to stop operating. This will generate a large uptick in business acquisition and asset purchases. If the target business received a PPP loan, some extra caution and extra due diligence will be needed. Here is why.

As noted, PPP loans are administered by the SBA. In general, if an SBA loan is involved, then SBA approval is needed if the relevant business is being sold and there is a “change in ownership.” This is similar to the type of approval needed with private lender financing.

SBA approval might also be needed for an asset purchase if substantially all of the assets are being sold and the business that obtained the PPP loan is expected to stop business operations. We say “might” because the SBA regulations are in flux (and have been since the CARES Act was passed). Interim regulations and guidance by the SBA earlier in the pandemic suggested that, for purposes of PPP loans, the SBA would not distinguish between a sale involving change of ownership and an asset purchase if substantially all the assets are sold. However, the SBA may have modified its approach. This is why an extra level of caution should be taken if the target business obtained a PPP loan. Note that, if it is needed, obtaining SBA approval is a lender responsibility. Thus, it may be wise to direct extra time and effort towards working with the lender to ensure timely approval (or to obtain a timely determination that no SBA approval is needed).

Note further that the larger the PPP loan, the more scrutiny the loan will receive from the SBA and other financial regulators. In particular, the SBA and the Treasury Department have signaled their intention to closely review all PPP loans greater than $2 million.

Fraud and deception related to use and to forgiveness of PPP loans are additional issues that should be explored during due diligence. As the New York Times noted here, sometimes the fraud will be easy to see such as the use of the PPP funds for diamond-encrusted Rolexs, gambling sprees, Lamborghinis, Escalades, and Rolls-Royces. Other fraud will be more difficult to ferret out.

Other due diligence items should include:

Review of the PPP application and the borrower’s certification of need
Consideration of whether the business obtaining the PPP loan was eligible and whether the amount received was proper and reasonable
Review of records with respect to how the loan was used
What amount (if any) of the PPP was forgiven
Review of records with respect to whether the expenses paid for with the PPP loan were of the type that were eligible for forgiveness
And more

Likewise, the Purchase Agreement should contain various additional representations and warranties to cover these issues. Successor liability issues should also be examined closely.

If you have questions or need legal assistance with buying or selling a business, contact the business lawyers at Revision Legal at 231-714-0100.

SBA Change of Ownership Rules: The Regulatory Framework

The Small Business Administration issued Procedural Notice 5000-20057 in October 2020, which provided the most concrete guidance to date on how PPP loans interact with business sales. The notice distinguished between transactions involving less than 20 percent of the ownership or assets of the borrower, transactions involving 20 to 50 percent, and transactions involving more than 50 percent. For the higher-threshold transactions, the notice required that the PPP borrower notify its lender prior to closing and, depending on the loan balance and whether forgiveness has been applied for, take specified steps including placing funds in an escrow account or obtaining lender and SBA approval.

The core principle is that the federal government’s interest in the repayment or forgiveness of a PPP loan does not automatically disappear when a business is sold. Until full forgiveness is granted or the loan is repaid, the loan represents a contingent liability that can follow either the surviving business entity or the acquired assets, depending on how the transaction is structured and what representations were made in the forgiveness application.

Asset Purchases vs. Stock Sales: Why Structure Matters

In a traditional asset purchase, the buyer selects specific assets and typically does not assume the seller’s liabilities unless the purchase agreement explicitly says so. PPP loans complicate this principle. If the seller used PPP funds for purposes that do not qualify for forgiveness, the loan remains outstanding. A buyer who acquires substantially all of the assets of a business that has an outstanding PPP loan may find the SBA arguing that the acquisition triggered an unauthorized change of ownership or that the escrow and approval requirements were not satisfied.

By contrast, in a stock sale or merger, the acquirer assumes all liabilities of the target entity by operation of law, including any PPP loan liability. Due diligence must therefore include a full review of the PPP loan application, the forgiveness application if one has been submitted, the supporting payroll documentation, and any SBA audit correspondence. Forgiveness is not automatic—the SBA has authority to audit PPP loans and to recapture proceeds used for ineligible purposes even after initial forgiveness approval.

Due Diligence Checklist for PPP-Affected Transactions

Obtain copies of the PPP loan application, promissory note, and any lender correspondence.
Determine whether a forgiveness application has been submitted and, if so, obtain all supporting documentation including payroll records, rent and utility receipts, and certifications.
Confirm whether the SBA has approved, partially approved, or denied forgiveness.
Check whether the loan amount exceeds $2 million, which triggered mandatory SBA audit eligibility.
Review the purchase agreement to determine whether any PPP liability will be retained by the seller, assumed by the buyer, or addressed through escrow.
If required, obtain the PPP lender’s written consent to the transaction prior to closing.
Obtain an indemnification from the seller covering any post-closing SBA recapture or audit finding related to the PPP loan.

Representations, Warranties, and Indemnification

The acquisition agreement should include robust representations and warranties from the seller addressing: accuracy of all certifications made in the PPP loan application, including the good-faith certification that economic uncertainty made the loan necessary; proper use of PPP funds only for eligible expenses; full compliance with SBA requirements regarding change-of-ownership notifications; and the absence of any ongoing SBA audit or investigation. A corresponding indemnification obligation should require the seller to defend, indemnify, and hold the buyer harmless from any post-closing SBA action seeking repayment of PPP funds.

Given that SBA audit authority extends for six years from the date of the loan application, the survival period for these representations and indemnities should be set accordingly—or at a minimum should extend beyond the standard one- to two-year survival period typical for commercial representations.

If you are buying or selling a business and want guidance on how PPP loans affect the transaction structure, due diligence, or the purchase agreement, contact the business lawyers at Revision Legal at 231-714-0100.