Our law firm conducted a webinar on this last week with Forbes contributor Bruce Blumberg. You can view the video by clicking here. The PowerPoint is available by e-mailing me at email@example.com and putting “necessary” in the subject line.
We will be presenting an update webinar Tuesday, May 5th at 9:00 AM EDT which you can attend by clicking here.
The CARES Act
There has been a remarkable national effort to get monies into the hands of small businesses and professional entities under the Payroll Protection Program (“PPP”) of the CARES Act that was signed into law on March 27th, 2020. I am summarizing the situation in the early part of this post, and then getting down to the nitty gritty in the section entitled Taking an Unnecessary PPP Loan May Result in Criminal Consequences.
The vast majority of American businesses and professionals have had significant reductions in revenues, increased expenses, and a tremendous degree of uncertainty and concern as to what will occur in upcoming weeks and months.
Bill Gates, who is one of the most well-versed individuals on infectious disease management from a business and practical standpoint, has indicated that vaccines and other “development[s] usually take around five years.” He states optimistically that there may be a vaccine for COVID-19 in as early as two years, but remains realistic by adding “this would be the fastest scientists have created a new vaccine.” He notes that even with the development of a vaccine, 7 to 14 billion vaccines would still need to be manufactured and delivered all around the world. Two years and billions of vaccines already seems a long ways away, and a number of important American industries may be waylaid for even longer than this as the impacts of the virus continue to unravel.
Forecasts of the economic impact of COVID-19 have been overwhelmingly bleak for 2020. The International Monetary Fund issued its 2020 World Economic Outlook in mid-April, projecting a world-wide 3% economic contraction, with the U.S. projected to bear a hefty 5.9% economic contraction. The report indicates that the economic downturn is currently worse than the 2008-09 financial crisis, and that COVID-19’s impacts will cause the “global economy to experience its worst recession since the Great Depression,” referring to this phenomena as “the Great Lockdown.” These projections are nearly verified in real-time with 30 million Americans having already applied for unemployment benefits and the number growing exponentially each week.
The PPP was intended to help enable small businesses and professionals to keep their employees on payroll, and to pay utilities, rent, interest, health insurance and pension contributions. These are essential operating expenses of a business that are required for a business to stay afloat.
The PPP loan maximum is generally based upon 2.5 times the monthly average for a business’s last twelve months (or 2019) expenses for payroll, health insurance and pension contributions.
The amount borrowed can be forgiven to the extent that it is spent during the eight weeks (56 days) following receipt of the loan proceeds, provided that at least 75% is spent on payroll, medical insurance and pension contributions, with the remaining 25% being spent on rent, interest, and utilities, based upon arrangements that were in place on or before February 15, 2020.
The above is an over-simplified summary of the act. A much more thorough summary can be found here, courtesy of the amazing Tony Nitti.
Taking an Unnecessary PPP Loan May Result in Criminal Consequences
It has been announced that PPP loan applications will be audited, which raises the question of what the meaning of the words “necessary to support the on-going operations of the applicant” actually mean.
If the loan is found not to be “necessary,” criminal fines of up to $1,000,000 and imprisonment for up to thirty years can be imposed.
The initial FAQ issued on April 23rd by the SBA and U.S. Treasury Department following press conference discussions included the following question and answer:
- “31. Question: Do businesses owned by large companies with adequate sources of liquidity to support the business’s ongoing operations qualify for a PPP loan?
- Answer: In addition to reviewing applicable affiliation rules to determine eligibility, all borrowers must assess their economic need for a PPP loan under the standard established by the CARES Act and the PPP regulations at the time of the loan application. Although the CARES Act suspends the ordinary requirement that borrowers must be unable to obtain credit elsewhere (as defined in section 3(h) of the Small Business Act), borrowers still must certify in good faith that their PPP loan request is necessary. Specifically, before submitting a PPP application, all borrowers should review carefully the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” 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, and such a company should be prepared to demonstrate to SBA, upon request, the basis for its certification” (emphasis added).
This question specifically asked whether large companies would qualify, but the answer addressed “all borrowers.” The uncertainty surrounding who may qualify and what determines if the loan is “necessary” were still present following this answer, and continues to persists, while somewhat clarified and somewhat muddied by the following.
A new FAQ from the SBA and Treasury Department was issued on April 28th and provided the following question-and-answer, which attempted to address the existing problem:
- “37. Question: Do businesses owned by private companies with adequate sources of liquidity to support the business’ on-going operations qualify for a PPP loan?
- Answer: See response to FAQ #31.”
The confusion about what “necessary” means is kicked back to the answer that created it in the first place in the April 29th update, and no official clarification has been offered since.
Despite the confusion, the SBA has announced a grace-period for businesses that do not “need” the loan—according to the SBA, they can return it by May 7th to avoid any criminal consequences related to taking a PPP loan unnecessarily.
This capability comes from the answer to question 31 of the April 23rd version of the FAQ issued by the SBA and Treasury Department, reading in relevant part:
- “Lenders may rely on a borrower’s certification regarding the necessity of the loan request. Any borrower that applied for a PPP loan prior to the issuance of this guidance and repays the loan in full by May 7, 2020, will be deemed by SBA to have made the required certification in good faith.”
The above guidance, and lack thereof, puts thousands of businesses in a quandary as to whether they should keep or receive PPP loan money to save their business, or give it back to reduce possible investigation and punishment.
In many cases businesses have enough money to stay in business for a few months, but not enough to stay in business for a year. A reasonable business person would certainly find PPP money to be “reasonable and necessary” to shore up a balance sheet in case things stay the same or even get worse in the upcoming weeks and months, but will the SBA agree, since they don’t seem to now?
Here are some thoughts on the situation.
The Term “Necessary” is Very Vague, So Civil and Especially Criminal Liability Might be Hard to Impose
The meaning of “necessary” is vague and ambiguous as it is not adequately defined. Multiple clarifications have been issued, but the provision of such clarifications shows how vague and ambiguous the “necessary” requirement is.
The SBA even interpreted their own rules against their current guidelines by approving applications from hedge funds and other large business entities with sufficient cash and revenue to maintain current operational expenses. If those entities thought they were eligible and the SBA apparently agreed by approving the applications, then it seems clear that reasonable parties on both sides can differ on how these words should be interpreted.
The new guidelines issued on April 23rd clarified that businesses “must take 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 in determining their eligibility.” Before the above guidelines were issued, applicants who would not qualify were already approved, and the provision has not been applied the same way throughout the short existence of the program because of the new guidelines.
Based upon the above circumstances, the statute and the requirements surrounding PPP loan eligibility could potentially be considered to be unconstitutionally vague for applicants who applied before notice was given on April 23rd, and possibly for those businesses that applied for PPP loans after April 23rd that are subject to circumstances not addressed in the Joint Committee Report.
Additionally, the April 29th FAQ update by the SBA and Treasury Department added the following question-and-answer:
- “39. Question: Will SBA review individual PPP loan files?
- Answer: Yes. In FAQ #31, SBA reminded all borrowers of an important certification required to obtain a PPP loan. To further ensure PPP loans are limited to eligible borrowers in need, the SBA has decided, in consultation with the Department of the Treasury, that it will review all loans in excess of $2 million, in addition to other loans as appropriate, following the lender’s submission of the loan forgiveness application. Additional guidance implementing this procedure will be forthcoming.
- The outcome of SBA’s review of loan files will not affect SBA’s guarantee of any loan for which the lender complied with the lender obligation set forth in paragraph III.3.b(i)-(iii) of the Paycheck Protection Program Rule (April 2, 2020) and further explained in FAQ #1.”
This answer indicates the SBA has almost certainly approved applications for loans that may not have actually been following their constantly-developing guidelines, since many loans will be audited upon the request for forgiveness for certification of compliance, meaning they have already been approved and the loan amounts distributed. This displays irregular application of a requirement that may lead to criminal charges, which is a regularly considered factor when analyzing whether a statute is “unconstitutionally vague.”
Unconstitutional vagueness was addressed in 1926 by the U.S. Supreme Court in its opinion in Connally v. General Construction Co. This case expanded the “vagueness doctrine” to “a statute which either forbids or requires the doing of an act in terms so vague that men of common intelligence must necessarily guess at its meaning and differ as to its application.” Essentially, if reasonable individuals cannot discern the conduct being punished by the statute, the statute did not provide fair notice of what acts were criminal, thus the statute is unconstitutionally vague.
In 2015, the U.S. Supreme Court expanded the vagueness doctrine once more in Johnson v. United States. The Court added to the doctrine a statute that is “so vague that it fails to give ordinary people fair notice” of the conduct which will be punished. It also includes the arbitrary enforcement of laws.
Here, the “necessary” requirement not only differs in reasonable interpretation, but it also failed to give reasonable notice of the specific conduct prohibited by the requirement, especially prior to the April 23rd updates. It has also been arbitrarily applied, since hedge fund businesses and other large businesses have been approved for their submitted applications that would now no longer qualify simply because they are publicly traded or hedge funds; notwithstanding that publicly traded companies and hedge funds often run out of money and go bankrupt.
These facts indicate the statute at the very least contains vague standards that may render the statute unconstitutionally vague, and thus totally unenforceable. However, businesses should not rely on this possibility when determining whether to apply, keep, or return a loan. Businesses should contact experienced legal counsel to determine the best option for their specific circumstances.
The “Necessary” Requirement Prevents Businesses Not in “Need” From Obtaining PPP Loans
Business owners are well aware that businesses have significant needs in terms of capital. This is especially true for the vast majority of companies that are in the hospitality and live entertainment industries, in that most of these enterprises have been shut down completely, or almost completely, due to the coronavirus and related stay-at-home orders. It is easy to see how a very large, cash-rich company that is completely closed during the virus would foresee economic hardship ahead.
Businesses that have sufficient capital reserves and/or revenue that can cover normal business operational expenses for a number of months may not meet the “necessary” definition, but the possibility of a key professional coming down with COVID-19 and business interruption insurance not covering pandemic-related scenarios create an obvious need for capital.
While some businesses might still have sufficient capital or revenues to cover operational expenses for several months, it does not mean their futures are certain. Bill Gates recently indicated that it could take five years to have an effective vaccine in the hands of medical practitioners. How many months or years of operating capital does a company need to make additional available funds under the PPP program “necessary?” The fact that Congress and the Small Business Association concluded that two and a half months’ payroll would be an appropriate measure of PPP loans, this would be evidence that this is an appropriate amount of added capital that almost every United States trade or business is in need of to shore up their financial statement and survival in the long run.
The above does not even take into account the severe recession that may occur shortly after or during the time that most Americans can return to whatever jobs still exist, and engage in economic activities, to the extent that they have money and confidence to do so.
The term “necessary” has been officially defined over many different sources over a long period of time. Starting in 1819, the Supreme Court case of McCulloch v. State considered whether the word “necessary” must “always import an absolute physical necessity, so strong, that one thing to which another may be termed necessary, cannot exist without that other.” The Court decided it did not, explaining that the word necessary “frequently imports no more than that one thing is convenient, or useful, or essential to another.”
“Necessary” was considered once again in 1933 in the Supreme Court case of Welch v. Helvering. A taxpayer attempted to claim a deduction for “ordinary and necessary” business expenses. The description of these expenses are now found in the Internal Revenue Code § 162. The Court accepted the taxpayers’ arguments, stating that the expenses qualified for the deduction because the expenses “were appropriate and helpful.”
The standard in Welch is noticeably lower than the standard in McCulloch, even though both cases deal with the same term. Progressively, cases have become increasingly lax on what is viewed to qualify for the § 162 deduction. Limousine services, first-class airfare, and large salaries are all found to be qualifying § 162 expenses in the case law interpreting it.
The IRC does not stop at “ordinary and necessary” expenses in its exploration of defining the term “necessary.” The Accumulated Earnings Tax imposes a tax on corporations (other than S corporations) that have capital reserves that are in excess of “the reasonable needs of the business.” These regulations are covered in IRC §537 and include “product liability loss reserves,” needs “directly connected” to the corporation, and “bona fide business purposes.” §537 also accounts for the “reasonable future needs” of the business based upon what “a prudent businessman would consider appropriate for the present business purposes and for the reasonably anticipated future needs of the business.”
The following are excerpts from the Accumulated Earnings Tax statute:
- §1.537-1 Reasonable needs of the business.
- (a) In general. The term reasonable needs of the business includes (1) the reasonably anticipated needs of the business (including product liability loss reserves, as defined in paragraph (f) of this section), (2) the section 303 redemption needs of the business, as defined in paragraph (c) of this section, and (3) the excess business holdings redemption needs of the business as described in paragraph (d) of this section. See paragraph (e) of this section for additional rules relating to the section 303 redemption needs and the excess business holdings redemption needs of the business. An accumulation of the earnings and profits (including the undistributed earnings and profits of prior years) is in excess of the reasonable needs of the business if it exceeds the amount that a prudent businessman would consider appropriate for the present business purposes and for the reasonably anticipated future needs of the business. The need to retain earnings and profits must be directly connected with the needs of the corporation itself and must be for bona fide business purposes. For purposes of this paragraph the section 303 redemption needs of the business and the excess business holdings redemption needs of the business are deemed to be directly connected with the needs of the business and for a bona fide business purpose. See §1.537-3 for a discussion of what constitutes the business of the corporation. The extent to which earnings and profits have been distributed by the corporation may be taken into account in determining whether or not retained earnings and profits exceed the reasonable needs of the business. See §1.537-2, relating to grounds for accumulation of earnings and profits.
- (b) Reasonable anticipated needs.
- (1) In order for a corporation to justify an accumulation of earnings and profits for reasonably anticipated future needs, there must be an indication that the future needs of the business require such accumulation, and the corporation must have specific, definite, and feasible plans for the use of such accumulation. Such an accumulation need not be used immediately, nor must the plans for its use be consummated within a short period after the close of the taxable year, provided that such accumulation will be used within a reasonable time depending upon all the facts and circumstances relating to the future needs of the business. Where the future needs of the business are uncertain or vague, where the plans for the future use of an accumulation are not specific, definite, and feasible, or where the execution of such a plan is postponed indefinitely, an accumulation cannot be justified on the grounds of reasonably anticipated needs of the business.
- (2) Consideration shall be given to reasonably anticipated needs as they exist on the basis of the facts at the close of the taxable year. Thus, subsequent events shall not be used for the purpose of showing that the retention of earnings or profits was unreasonable at the close of the taxable year if all the elements of reasonable anticipation are present at the close of such taxable year. However, subsequent events may be considered to determine whether the taxpayer actually intended to consummate or has actually consummated the plans for which the earnings and profits were accumulated. In this connection, projected expansion or investment plans shall be reviewed in the light of the facts during each year and as they exist as of the close of the taxable year. If a corporation has justified an accumulation for future needs by plans never consummated, the amount of such an accumulation shall be taken into account in determining the reasonableness of subsequent accumulations.
- (f) Product liability loss reserves.
- (1) The term product liability loss reserve means, with respect to taxable years beginning after September 30, 1979, reasonable amounts accumulated for the payment of reasonably anticipated product liability losses, as defined in section 172(j) and §1.172-13(b)(1).
- (2) For purposes of this paragraph, whether an accumulation for anticipated product liability losses is reasonable in amount and whether such anticipated product liability losses are likely to occur shall be determined in light of all facts and circumstances of the taxpayer making such accumulation. Some of the factors to be considered in determining the reasonableness of the accumulation include the taxpayer’s previous product liability experience, the extent of the taxpayer’s coverage by commercial product liability insurance, the income tax consequences of the taxpayer’s ability to deduct product liability losses and related expenses, and the taxpayer’s potential future liability due to defective products in light of the taxpayer’s plans to expand the production of products currently being manufactured, provided such plans are specific, definite and feasible. Additionally, a factor to be considered in determining whether the accumulation is reasonable in amount is whether the taxpayer, in accounting for its potential future liability, took into account the reasonably estimated present value of the potential future liability.
- (3) Only those accumulations made with respect to products that have been manufactured, leased, or sold shall be considered as accumulations made under this paragraph. Thus, for example, accumulations with respect to a product which has not progressed beyond the development stage are not reasonable accumulations under this paragraph.
If §537 were adopted for the standard of PPP loans, the above makes it seem as though most businesses would qualify for them on the basis of “necessity.”
EIDL Loans May be Instructive
The SBA may not have guidance for the term “necessary” for PPP loans, but other loans the SBA offers, like the Economic Injury Disaster Loan (EIDL), provide a helpful reference.
To qualify for EIDL, the applicant must have suffered “substantial economic injury” as a “direct result” of COVID-19, or another applicable disaster. Substantial economic injury usually entails a decrease in working capital or income from normal operations, resulting in the business being unable to meet its obligations. The substantial economic injury requirement of EIDLs is akin to the necessary requirement issued for PPP loans, as substantiated by the guidance released by the SBA and Treasury Department on April 23rd.
Senator Rubio’s Tweets
U.S. Senator Marco Rubio (R-FL) responded to concerns of hedge funds or other large entities apparently qualifying for and receiving PPP loans, releasing an official statement as the U.S. Senate Chairman of the Committee on Small Business and Entrepreneurship. Senator Rubio mentioned that the “necessary” requirement will be enforced and that companies that do not really need the loans should return the funds. Senator Rubio’s statements were likely intended to have a positive effect and to preserve money for those businesses that need it the most, but did not provide the clarity many taxpayers desperately need and do not hold the precedence the statements would have held if they were in a Committee Report.
PPP loans must be necessary for a business to support its on-going operations, otherwise serious criminal liability could present itself. Avoiding this liability depends on what the term “necessary” means, and whether the confusion surrounding its meaning allows for its enforcement.
Given the recent updates from the SBA, Treasury Department, and Senator Rubio, the term “necessary” likely means that the business needs the funds and does not have revenue to cover its operating expenses.
The SBA will be auditing PPP loan recipients for their eligibility. If it is found that a business falsely claimed they needed the PPP loan and did not return it by May 7th, criminal liability may apply.
Businesses should seek competent advice from experienced legal counsel to ensure their eligibility with PPP loans and to examine any existing PPP loans to determine whether it is truly “necessary” for the business.
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