Tyler Hendry and James Robinson of Herbert Smith Freehills summarize the restructurings and PPP loans in the shadow of COVID-19, and how this has affected deal-making in 2021.
Before the pandemic, employment-related due diligence was, in many cases, an autopilot exercise. While there were certain complexities, it was rare to address issues never before seen. COVID-19 has changed this.
Many deals are being conducted in the shadow of significant layoffs/furloughs and/or restructurings. In addition, to stay afloat and cover payroll costs, over 700,000 businesses obtained potentially forgivable loans through the federal government's Paycheck Protection Program ("PPP").
This combination of restructurings and PPP loans – mixed with a slate of new COVID-related employment safety laws – has thrust novel employment issues to the forefront of 2021 deal making.
Below, we summarize these issues and the various practical approaches parties have taken to address them.
Traditional Employment Considerations
In the first category are new issues arising from traditional diligence considerations, such as layoffs, leave, and workplace safety. Specifically:
- WARN Act compliance. The Worker Adjustment and Retraining ("WARN") Act requires an employer to provide 60 days' notice for mass layoffs/closings that meet certain employee thresholds. Pre-pandemic, determining whether employee thresholds were met was generally straightforward and a valid defense for failing to provide timely notice (e.g., for unforeseeable business circumstances) were rare. During the pandemic, these calculations have been complicated by layoffs that have occurred in unexpected waves, as well as murky questions on when a furlough should be considered a layoff. In addition, many employers have relied on the unforeseeable business circumstance defense to justify their failure to provide notice, but the scope of this defense is more limited than one would expect from the title, and there has been significant litigation over its proper scope.
- COVID-19 laws. In response to COVID-19, federal, state, and local lawmakers have implemented a patchwork of laws relating to, among others, paid leave, workplace safety, and benefit plans. As HR staffs handle the myriad of pandemic-related issues, implementing these mandated policies has often fallen through the cracks.
- Remote workers. Employers have (understandably) championed flexibility – in many cases allowing employees to work remotely from states where the employer has no physical office. From an employment law perspective, this work location is significant. Pre-pandemic, the majority of states took the position that one employee working from home while physically located within a state could subject an employer to employment registration and other requirements where the employee is located.
The key to COVID-19 diligence is asking the right questions; RFIs must be tailored to specifically seek COVID-related changes to the workforce, including information on remote work locations, COVID-19 policies, and specific details on employees that have been laid off/furloughed or suffered a reduction in pay/hours.
For WARN Act compliance issues, buyers typically request full indemnities, but the most common end result when there are no glaring compliance issues is a representation and warranty. If however, the seller has not provided timely notice and relied on the unforeseeable business circumstance defense in doing so, an indemnity is often given.
For COVID-19 law compliance issues, the almost universal approach has been a representation and warranty, except in those instances where a seller has wholly disregarded its legal obligations; in these instances, indemnities are appropriate.
Approaches on the remote worker risk have varied. To date, state governments have been lenient and not actively pursued employers with employees working in different states because of the pandemic. It is difficult to predict how long this leniency will last as things return to some form of normal. For protection, many buyers have found it sufficient to rely on a standard representation and warranty that the seller is registered in those locations where it is legally required to be registered. However, some employers have viewed this as a more significant risk, particularly for those businesses with longer-term work-from-home plans.
PPP loans are available to "small businesses" – generally defined as businesses with 500 or fewer employers – and they are potentially forgivable loans for up to 2.5 times the employer's monthly payroll costs (up to a maximum of $10 million). To obtain loan forgiveness, an employer must comply with certain conditions, including spending at least 60 percent of the funds on payroll costs, and it must submit an application to obtain forgiveness. If forgiveness is denied, the loan must be repaid at a 1 percent interest rate. These loans and questions surrounding them have been a focal part of transactions, including:
- Does the transaction require Small Business Administration ("SBA") approval? Any transaction that requires SBA (the entity overseeing loan program) consent can add at least 60-90 days to the transaction process. Early in the pandemic, the standard PPP loan contained language that any "change of ownership" required SBA consent, and there was no guidance on this definition. In October 2020, the SBA finally clarified this point.
- Stock sale. SBA consent is required only if the controlling interest is sold or otherwise transferred, and consent can be avoided if the PPP borrower completes the forgiveness application and establishes an interest-bearing escrow account controlled by the PPP lender for the outstanding balance of the loan.
- Asset sale. In an asset sale (of at least 50 percent of the PPP borrowers' assets), SBA consent is required unless the PPP borrower similarly completes the forgiveness application and creates an escrow account.
For ownership changes of 20 percent or more (but less than 51 percent), there are certain notice requirements, but the lengthy SBA consent process can be avoided.
- Did obtaining the PPP loan violate any existing loan agreements? During the diligence process, an entity often discovers for the first time that obtaining the PPP loan violated the terms of an existing loan/line of credit agreement. Most lenders were lenient in waiving any such conditions for those borrowers who made the request, but in the rush for emergency funds, many PPP borrowers did not recognize the potential breach and/or seek the requisite approvals required to obtain the PPP loans.
- What if the buyer also has a PPP loan? Early in the pandemic, companies were fearful that buying a business that would result in the company having two outstanding PPP loans would result in a default under the loan agreement; guidance has confirmed this is not the case. The entities must segregate the PPP funds and payments made to comply with the terms of the loan so that both entities will be able to properly show compliance for both loans.
If a business may be interested in a deal, it should complete the loan forgiveness application as soon as it is legally able to do so. The level of diligence required and the overall process is much smoother when an application is in process as this application should contain the proof necessary to show the funds were used for their intended purpose.
As part of the diligence process, a buyer must not only properly diligence whether the loan was used for its intended purpose, but also the seller's eligibility for the loan in the first place. One of the most frequent errors is failing to count "affiliates" – as defined by the SBA – in determining whether the entity has 500 employees.
Finally, the parties must provide a mechanism to address the situation where the loan is ultimately not forgiven. The ideal situation is of course waiting for the application to be approved, but this is not always possible, and the most common approach in the circumstance is establishing an escrow account for the full amount of the loan. This approach avoids the need for SBA consent, and alleviates any risk of an unexpected denial.
Published June 23, 2021.