Due to recent guidance from the Small Business Association (SBA) and the Securities and Exchange Commission (SEC), registered investment advisers (RIAs) should carefully consider their eligibility for a loan under the Paycheck Protection Program, and whether they must disclose the circumstances that led to the loan, or the fact of receiving the loan itself, on form ADV.
The PPP Loan Certification
In order to qualify for a PPP loan, an applicant must certify that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Our view of this language was that it was very broad, so as to apply to any business that reasonably anticipated a reduction in revenue that could result in curtailment of its current operations. If an RIA believed in good faith that its revenue will decrease or has decreased as a result of the pandemic, and also anticipated that it will have to terminate any employees without the loan, then it is eligible for the loan. Since the primary purpose of the loan program was to minimize unemployment, in our view such an RIA should have easily been able to make the certification in good faith. However, later SBA guidance effectively altered the standard, and any RIA who applied for a loan should reevaluate the certification under the new standard.
April 23, 2020 — SBA Guidance
There was political backlash in mid-April when it was revealed that certain large companies, including publicly-traded companies that had access to capital markets, were receiving PPP loans. This led the Small Business Administration to issue formal Q&A guidance last Thursday, April 23, 2020. As a result of the guidance, the SBA stated that, 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. While it is tempting to read the SBA guidance as applicable only to large businesses with access to capital, the Q&A made it clear that the “significantly detrimental” standard applies to “all borrowers.”Furthermore, while the guidance could be interpreted to apply only to public companies, the SBA clarified that it applied to private companies by updated guidance issued on April 28, 2020.
This new standard is narrower. An RIA merely faced with anticipated layoffs is no longer eligible for the loan if it has access to capital that will not impair the business. For example, an RIA with an existing line of credit on customary terms or any other access to capital may, depending on the circumstances, be ineligible. Tacitly realizing the interpretation changed the standard, the SBA gave an applicant that cannot meet the new standard until May 7 to return the loan funds. Any applicant that has not yet received loan funds and who does not believe it can meet the new standard should withdraw its application.
Obligation to Disclose in Item 18 Form ADV, Part 2A
There are two possible reasons why an RIA may need to disclose its receipt of a PPP loan. First, Form ADV, Part 2A, at Item 18, contains the following instruction: “If you have discretionary authority or custody of client funds or securities, or you require or solicit prepayment of more than $1,200 in fees per client, six months or more in advance, disclose any financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.” Second, in addition to any specific question or instruction in the Form ADV, an RIA has a fiduciary duty to disclose to clients any material facts relevant to the advisory relationship with clients.
In the SEC’s 2010 release adopting amendments to Form ADV Part 2, the SEC states the following about the “financial condition” language in Item 18 of ADV 2A:
A determination about what constitutes financial condition reasonably likely to impair an adviser’s ability to meet contractual commitments is inherently factual in nature but will generally include insolvency or bankruptcy. For instance, disclosure may be required where a judgment or arbitration award was sufficiently large that payment of it would create such a financial condition. Under these circumstances, clients are exposed to the risk that their assets may not be properly managed — and prepaid fees may not be returned — if, for example, the adviser becomes insolvent and ceases to do business.
If an RIA is not insolvent or bankrupt, and is not currently experiencing a reasonable risk of being insolvent or bankrupt because of the coronavirus pandemic or for any other reason, then the receipt of a PPP loan does not require disclosure under Item 18 of Form ADV, Part 2A. Additionally, receipt of a PPP loan makes it less likely, not more likely, that an RIA receiving such a loan will become insolvent, since the loan has extremely favorable interest and forgiveness features. Consequently, receipt of a PPP loan makes it less likely, not more likely, that a disclosure under Item 18 will have to be made. Nevertheless, if an RIA perceives insolvency as a reasonable possibility, with or without the loan, then it should disclose that fact under Item 18.
Obligation to Disclose Arising from Fiduciary Duty
Aside from the disclosure required in Item 18 of Form ADV Part 2A, an RIA must disclose all material facts relating to the advisory relationship. This duty arises from the nature of the RIA’s fiduciary duty. As it relates to the PPP loan program, the key to whether such a disclosure would be required for that reason lies in the RIA’s ability to continue to provide uninterrupted service at its customary level of competency in light of the circumstances after receipt of the PPP loan.
April 27, 2020 — Formal SEC Guidance
On Monday, April 27, the SEC issued formal FAQ guidance on the disclosure issues. In that guidance the SEC stated:
As a fiduciary under federal law, you (the RIA) must make full and fair disclosure to your clients of all material facts relating to the advisory relationship. If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance. If, for instance, you require such assistance to pay the salaries of your employees who are primarily responsible for performing advisory functions for your clients, it is the staff’s view that you would need to disclose this fact. In addition, if your firm is experiencing conditions that are reasonably likely to impair its ability to meet contractual commitments to its clients, you may be required to disclose this financial condition in response to Item 18 (Financial Information) of Part 2A of Form ADV (brochure), or as part of Part 2A, Appendix 1 of Form ADV (wrap fee program brochure). (Posted April 27, 2020)
RIAs should resist the urge to interpret this guidance to mean that it must disclose the PPP loan only if it is using the loan funds to pay advisers. That was only referenced as an example. Whether a particular firm must disclose the loan will vary depending on the facts and circumstances of each adviser.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.