By David Tayman

The Federal Payroll Protection Program (PPP) has been a tremendous source of financial support for small and mid-sized businesses that have been hit hard by the economic consequences of the Covid-19 pandemic.  In two lightning-fast funding rounds, the Small Business Administration (SBA) authorized banks and lenders to make almost $500 billion in forgivable loans.  This is an astonishing volume of loans made over a very short period of time.  By way of comparison, in all of 2019, SBA lenders and banks made only $28 billion in loans.  Thus, the PPP loans represent an increase of almost 80 times the normal loan volume in the SBA lender system.  This kind of quick ramp up and execution on so many loans to so many borrowers has inevitably led to mistakes being made, and many loans may not be compliant with PPP guidelines and program requirements.  Indeed, the business news is replete with stories of companies that arguably should not have gotten PPP loans or benefited from this program.  Some examples include the L.A. Lakers, Shake Shack, public companies with other sources of capital, businesses that are too large, and companies that quite simply have not suffered an adverse impact because of the Covid-19 pandemic.

Will You Be Audited?

Treasury Secretary Steve Mnuchin has already announced that all PPP loans greater than $2 million will be audited.  Secretary Mnuchin has used words like “outrageous,” “unfortunate,” and “inappropriate” to describe these deemed improper loans and the companies that took PPP loans when they should not have.  To be clear, the problem and the risk here is for business borrowers, not for the banks who made these loans – Secretary Mnuchin has explicitly stated that “it’s the borrowers who have criminal liability” if they made false certifications on their loan applications.  Secretary Mnuchin’s public pronouncements have translated into guidance from the SBA that the SBA, “in consultation with the Department of the Treasury, will review all loans in excess of $2 million, in addition to other loans as appropriate….”

While companies that received $2 million+ in loan proceeds should definitely be prepared for an audit, the “in addition to other loans, as appropriate” language should raise alarm bells for all PPP borrowers.  If history is any guide, we can expect the SBA to significantly lower the monetary hurdle for automatic or semi-automatic PPP loan audits and we can expect that almost all companies operating in certain industries which are deemed to be less affected by pandemic-related financial distress to be the subject of an audit.

In addition, this is probably not a situation where a borrower can just return the funds and avoid liability because false certifications in a PPP loan application are deemed to be false statements made to the Federal Government.  As a result of this, a PPP borrower who is found to have made such false certifications could end up facing fines and penalties in excess of $250,000 and judgments 2 to even 3 times the amount of the original loan.  In addition, these false certifications also carry with them the potential for substantial criminal liability, including prison time.  At this point, it is expected that these audits will be conducted by personnel from the SBA’s Office of Inspector General.  Given the high volume of PPP loans relative to the SBA’s normal loan administration infrastructure, the SBA may look to other Federal Government agencies for help or support in conducting these audits, including the Department of the Treasury (which employs a legion of IRS auditors), the Department of Justice, and even the Defense Contract Audit Agency, a Department of Defense agency which regularly conducts audits and reviews of defense and non-defense government contracts and projects.  The SBA has made it clear that the audit process will begin “following the lender’s submission of the borrower’s loan forgiveness application.”  While this seems to imply that an audit can be avoided by not submitting a loan forgiveness application, the SBA has not expressly said this.  A PPP borrower should not expect to avoid an audit simply because the borrower did not submit a loan forgiveness application.

The Focus of The Audit

While the SBA has stated that further guidance on SBA audits will be forthcoming, it is clear the primary focus of PPP loan audits will be on whether the borrower has been truthful in its certification that (1) the loan was necessary; (2) the borrower met the enterprise size and other criteria for a PPP loan; (3) the borrower’s loan was not in excess of 2.5 times historical monthly payroll; and (4) the borrower did not intend to or actually misuse the proceeds of the PPP loan.

With respect to the business size and loan size parameters, a PPP audit is likely to focus on the borrower’s historical size data (number of employees, revenues, etc.) and the borrower’s historical payroll expenses.  The borrower’s ownership structure will be scrutinized relative to SBA affiliation standards to see if the borrower’s affiliates or owners should be considered part of the borrower when determining borrower size.  We expect the most contentious areas of PPP audits to be whether the loan itself was necessary and whether the borrower intended to and did use the PPP loan proceeds for a permissible purpose.

An audit into the necessity of a PPP loan will almost certainly focus on the economic situation the borrower was in when it applied for the loan.  In applying for the loan most borrowers were required to certify that “current economic uncertainty” made the PPP loan necessary to support the ongoing operations of the borrower.  The focus of an audit to investigate this factor would, therefore, focus on the borrower’s operations at the time of the application and how they may or may not have been affected by the Covid-19 pandemic.  Were other capital sources open to the borrower when it applied for the PPP loan?  Did the borrower have substantial resources on hand without the addition of the PPP loan proceeds that could have been used to fund operations?  Did the borrower have projections or other business assessments that showed an expectation of an adverse effect from the Covid-19 pandemic?

Permissible Use of PPP Proceeds

In terms of the proper use of PPP loan proceeds, those funds are to be used “to retain workers and make payroll or make mortgage interest payments, lease payments, and utility payments.”  In order to be forgivable, the mortgage interest payments and lease payments must be for mortgages or leases that were in place prior to February 15, 2020.  PPP loan proceeds must also be used to pay allowable, forgivable expenses incurred and paid during the 8 weeks after the actual disbursement of the PPP loan proceeds to the borrower.

What Should a PPP Borrower Show to Demonstrate Need?

While the ultimate outcome of a PPP audit will depend on case-specific factors (the borrower’s financial history, the details of the borrower’s position on all of these various elements, etc.), one thing that is clear is that PPP borrowers need to be prepared to present their files and documentation (electronic and hard copy) to make the case that they were entitled to their PPP loan.

Such documents and records include, but are not limited to, prior year tax returns, financials, payroll and payment records to support the amount, timing, and purpose of allegedly forgivable expenditures, bank and payment records that would allow the tracking of PPP loan proceeds, mortgage and lease documents, utility bills, and financial projections and business plans which show the borrower’s expectation or understanding of the adverse effect that the Covid-19 pandemic and the related financial distress is or was expected to have on the borrower’s operations.

Mitigating the Risk

All PPP borrowers who received $2 million or more under the program should begin assembling this documentation as soon as possible.  In addition, because it is anticipated that the pool of PPP audit targets will be much greater than just those borrowers who received $2 million or more, all PPP loan recipients would be well-advised to start assembling this documentation and information sooner rather than later.

The specter of a PPP audit hangs over virtually every recipient of a PPP loan.  The downside risk in this instance is high if it is later determined that a PPP loan was improper or that the borrower or its officers and/or directors made false certifications in obtaining the PPP loan.  That downside risk includes a wayward PPP borrower being forced to pay fines and/or penalties well in excess of the loan proceeds, possibly even 2 or 3 times the loan amount or more, or the possibility that a wayward PPP borrower will be found criminally liable.  Gathering the documents and information anticipated to be relevant to a PPP audit, and talking to an attorney familiar with government audits or reviews, is key to preparing for such an audit and key to optimizing the chances of a successful audit with no bad outcomes.

If you are facing a PPP audit, or if you want to prepare for one, Tayman Lane Chaverri, LLP can help and we welcome your inquiries.  For more information, please contact David Tayman, at [email protected] or (202) 695-8147.