Litigation and Regulatory Risks to Banks from Paycheck Protection Program
The Paycheck Protection Program (PPP) presents various risks to banks, including litigation from customers, prospective customers, and third parties, as well as enforcement actions from the government and bank regulatory agencies.
An analysis of the several dozen lawsuits filed in the months after the enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act reveals that PPP litigation is trending in five preliminary categories: PPP eligibility restrictions, PPP loan prioritization, agent fees, default on debt, and False Claims Act, each detailed below with other litigation risks.
The PPP also presents regulatory risk to banks, including but not limited to nonpayment of guarantee by the US Small Business Administration (SBA), fair lending risk, Bank Secrecy Act (BSA) compliance risk, and PPP compliance risk, each detailed below.
The PPP was established as part of the CARES Act, signed into law on March 27, 2020, to provide unsecured low interest rate loans to small businesses that have been impacted by the COVID-19 pandemic. PPP loans are funded by private lenders, including banks and financial services firms; are backed by the SBA; and are administered by the SBA in conjunction with the US Department of the Treasury (Treasury). The PPP provides for loan forgiveness of up to the full principal amount of qualifying loans. On April 24, 2020, $310 billion in funding was added to the initial $349 billion, bringing the total available PPP funding to $659 billion.
Eligibility Restrictions. One category of PPP litigation against banks involves prospective PPP loan applicants that claim they were unable to apply because of lender-specific policies that restricted PPP eligibility. In this category of PPP litigation, businesses have filed lawsuits, including putative class actions, alleging that banks imposed unlawful restrictions that required PPP loan applicants to have a preexisting borrowing relationship or deposit account with the bank, or that required applicants to not have a credit or borrowing relationship with another bank. These lawsuits have asserted claims for violation of the CARES Act and the SBA’s 7(a) loan program, negligence, unjust enrichment, declaratory judgment, and injunction to prevent banks from imposing restrictions on PPP borrowing, among other claims. Some lawsuits in this category have also asserted claims for violation of the Sherman Act and the Clayton Act, alleging that unlawful eligibility restrictions on PPP borrowing constitute a restraint of trade and anticompetitive conduct. In one early case on eligibility restrictions, a court issued a key opinion that the CARES Act did not establish a private right of action against banks. However, that legal opinion is not determinative in other cases and is the subject of ongoing litigation. Eligibility-restriction cases have been filed in various US district courts, including in Texas, Maryland, California, and other jurisdictions.
Loan Prioritization. Another category of PPP litigation against banks involves PPP loan applicants that claim their loan was denied because of lender-specific policies that prioritized certain PPP loan applications. In this category of PPP litigation, loan applicants have filed lawsuits, including putative class actions, alleging that banks did not process PPP applications on a first-come, first-served basis, and instead unlawfully prioritized applications based on the loan amount, origination fee amount, size of the business applicant, and nature and extent of a client relationship. Applicants alleged that their loan applications were denied as a result of the unlawful loan prioritization. These lawsuits tend to allege that PPP loans are required to be processed on a first-come, first-served basis, which is a reference to guidance to PPP borrowers in the SBA Interim Final Rule issued on April 2, 2020. These lawsuits also tend to reference the processing fees paid by the SBA to lenders for processing PPP loans — i.e., 5% for loans of not more than $350,000; 3% for loans between $350,000 and $2 million; and 1% for loans of at least $2 million — which are contained in the SBA Interim Final Rule and the PPP Information Sheet for Lenders (PPP ISL). These loan-prioritization lawsuits have asserted claims for breach of contract, unfair business practices, violation of consumer protection laws, negligence, breach of fiduciary duty, fraudulent concealment, false advertising, and unjust enrichment, among other claims. Loan-prioritization cases have been filed in various US district courts, including in Texas, California, New York, Illinois, Colorado, and other jurisdictions.
Agent Fees. Another category of PPP litigation against banks involves agents that claim banks have unlawfully withheld fees owed to agents for assisting in the PPP application process. Under the PPP, an agent, such as an accountant or consultant, can assist a lender with originating and preparing a PPP loan application. The PPP ISL provides in part that “[a]gent fees will be paid out of lender fees. The lender will pay the agent.” The SBA Interim Final Rule and the PPP ISL also establish the maximum fee that an agent may collect from a lender. In this category of PPP litigation, agents have filed lawsuits, including putative class actions, alleging that banks improperly withheld agent fees that must be paid out of the lender fees paid by the SBA to lenders. These agent-fee disputes raise issues regarding the source, amount, and timing of payment of fees to agents. Agents have also alleged that banks have improperly refused to accept loan applications from agents until agents acknowledged that no fees would be due from the bank. Agent-fee lawsuits have asserted claims for violation of the CARES Act and SBA’s 7(a) loan program, unfair business practices, violation of consumer protection laws, unjust enrichment, conversion, quantum meruit, and declaratory relief, among other claims. Agent-fee cases have been filed in various US district courts, including in Texas, California, New York, Illinois, Colorado, Florida, and other jurisdictions.
PPP Loan as Default on Existing Debt. Another category of PPP litigation against banks involves prospective PPP loan applicants that claim that PPP loans should not constitute new debt that would trigger a default under existing loan agreements. In this category of PPP litigation, loan applicants have sought a declaration regarding the enforceability of a loan agreement’s default provision regarding new debt, and whether the PPP loan constitutes a default thereunder.
False Claims Act. Under the False Claims Act (FCA), the Department of Justice (DOJ) may bring an enforcement action against a party for knowingly or recklessly submitting a false claim for payment to the federal government. The FCA also allows private persons to file a civil suit for violations of the FCA on behalf of the government. The FCA authorizes various relief, including the potential for treble damages, civil penalties, and criminal liability. The SBA has indicated that it will “hold harmless” PPP lenders that rely on borrower attestations and documentation, but that hold-harmless arrangement assumes a lender’s compliance with certain requirements, and it is unclear whether it would extend to circumstances involving bank knowledge that contradicts borrower certifications. Absent sufficient guidance from the DOJ, the risk of investigation or enforcement by DOJ or FCA action by a private litigant is not foreclosed. FCA actions and claims may also be brought against borrowers based on allegations of ineligibility, false certifications, and noncompliance with PPP requirements, among other things.
Other PPP Litigation Risks. PPP litigation trends suggest litigation risk exposure under both federal and state law. The PPP does not expressly authorize any private cause of action, but as evidenced by PPP litigation thus far, lenders may face state law claims based on the manner and timeliness of loan processing and underwriting, particularly given the unclear or inconsistent guidance. Other litigation risks may include state law consumer fraud and unfair business practice claims based on communications or statements by the bank regarding its PPP process and protocols. PPP litigation is still in its early stages, and litigation risk exposure will depend on a number of factors. Additional guidance and forthcoming court opinions will provide insight into the viability of litigation claims and defenses, and risk mitigation strategies.
Litigation Risk Mitigation. To protect against litigation risk, banks should consider systems and measures to avoid conduct that could be interpreted as benefiting the bank to the detriment of applicants; to disclose the terms of the bank’s PPP program, including any protocols for processing applications; to maintain consistent internal communication and documentation regarding the bank’s PPP program and lending practices; to document all agreements with agents and third-parties, including terms of payment; to prevent fraudulent or inaccurate calculations; to carefully consider and document the rationale for any PPP program practices that are subject to unclear Treasury guidance; to ensure fair lending, BSA, CIP, and other compliance; and other measures that may be appropriate given the specifics of the bank’s PPP program, procedures, size, and customer base. Banks should also consider mitigation of regulatory risk through the measures discussed below.
Regulatory Risks and Risk Mitigation
In addition to litigation risks associated with the PPP, banks must also be cognizant of the regulatory risk associated with the program. The following outlines the primary risks from a regulatory perspective.
Small Business Administration
Nonpayment of SBA Guarantee
One of the main risks associated with the program is the risk that the SBA will deny payment of its guarantee on a PPP loan. In the event that a PPP loan goes into default, a denial by the SBA of its guarantee would result in the lender having an unsecured loan that may not be repaid.
The SBA’s Interim Final Rule lists four actions a lender must take when underwriting PPP loans: (1) confirm receipt of borrower certifications contained in the PPP borrower application form; (2) confirm receipt of information demonstrating that a borrower had employees for whom the borrower paid salaries and payroll taxes on or around February 15, 2020; (3) confirm the dollar amount of average monthly payroll costs for the preceding calendar year by reviewing the payroll documentation submitted with the borrower’s application; and (4) follow applicable BSA requirements.
The SBA and Treasury issued supplemental guidance in the form of PPP Frequently Asked Questions (FAQ). The FAQ provides additional guidance on lender and borrower responsibilities in terms of the PPP loan process. One of the primary goals of the SBA and Treasury in launching the PPP was to get money into the hands of small businesses as quickly as possible. To facilitate this, the SBA Interim Final Rule and the FAQ allow lenders to substantially rely on the borrower in terms of providing certifications on program eligibility and certain other program requirements. For example, the SBA Interim Final Rule states, “SBA will allow lender to rely on certifications of the borrower in order to determine eligibility of the borrower and use of loan proceeds and to rely on specified documents provided by the borrower to determine qualifying loan amount and eligibility for loan forgiveness.” As another example, FAQ #1 states that providing an accurate calculation of payroll costs in the PPP application is the responsibility of the borrower and that the lender is expected to conduct a good faith review of the borrower’s calculations and supporting documentation. It further provides that if the lender identifies errors or lack of substantiation in the supporting documents, it should work with the borrower to remedy the issue.
The most likely issues that could lead to the SBA denying its guarantee include the lender’s failure to satisfy any of the four underwriting requirements set forth above, the lender’s failure to act in good faith when approving an application that it knew or reasonably should have known was ineligible under the program, or the loan amount being improperly calculated. Scenarios that could lead to issues on the guarantee include (1) the lender’s failure to notice that the borrower did not check the appropriate box on the certification form, resulting in the borrower being ineligible; (2) an error in the loan amount calculation that was apparent in the information submitted by the borrower to the lender; (3) the lender’s failure to obtain the required documentation evidencing the borrower had paid employees on February 15, 2020; and (4) the lender’s failure to properly obtain necessary BSA information on a customer when making a loan. It is possible that in certain situations the SBA could play Monday morning quarterback and attempt to assert that even though a lender met all four underwriting requirements, the lender knew or reasonably should have known that a borrower was ineligible or that other information provided by the borrower was inaccurate.
To mitigate the risks associated with the SBA guarantee, the lender should review each PPP loan and make sure all four underwriting requirements set forth above have been met and ensure the loan file contains documentation supporting each of the four requirements. If the lender submits a request to the SBA to pay on the guarantee, the SBA will request a copy of the entire loan file, and it will be important to demonstrate that all underwriting requirements were met. The risk is enhanced for loans of $2 million or greater, as SBA has indicated that these loans will be subject to an automatic audit and will receive more scrutiny. Further, when making a PPP loan, if the lender has concerns regarding borrower eligibility or the permissible loan amount, it should seek additional information to satisfactorily address the concern. While it may substantially rely on borrower certifications, it should not ignore a certification that it knows or reasonably should know to be false. For example, if the lender has concerns over borrower eligibility, it might consider asking the borrower to obtain a legal opinion from the borrower’s legal counsel to support its application.
Bank Regulatory Agencies
Banks must also be prepared for review of its PPP loans by its federal and state bank regulatory agencies. The banking agencies will be evaluating certain compliance issues relating to the PPP, including fair lending compliance, BSA compliance, and PPP program compliance. If the banking agencies discover a violation in these areas, depending on the severity of that violation, it could result in criticism in the report of examination, a downgrade in CAMELS ratings, or the potential for an enforcement action.
Fair Lending Risk
The most significant compliance risk from a banking agency examination standpoint is the risk of fair lending issues associated with a bank’s PPP loan program. As discussed above, there have been several lawsuits and complaints by borrowers about the process banks used in evaluating and processing PPP loan applications. Many banks prioritized working with existing customers over new customers in making PPP loans, for many prudent and sound reasons, including the volume of applications being submitted compared with the bank’s bandwidth for processing them, the speed with which the program was being rolled out, the finite amount of money available under the program initially, and differences in the amount of information needed for BSA requirements. A bank’s approach to processing PPP applications could enhance the risk of a disproportionate impact on minority- or women-owned business applicants. At least one banking agency has already issued guidance on this topic. The Office of the Comptroller of the Currency issued a bulletin on April 27, 2020, in which it advised banks under its supervision to prudently document their implementation and lending decisions and encouraged banks to identify and track PPP loans made to small business borrowers with less than $1 million in annual revenue located in low- to moderate-income areas.
There are certain steps a bank can take to mitigate fair lending risk. For example, a bank should document the legitimate nondiscriminatory business reasons for its method of processing PPP applications. This can be provided to examiners if necessary to justify its loan approval process. A bank should also take steps to monitor the implementation of its PPP application process (including exceptions to such process) and whether it is having a disproportionate impact on certain types of protected classes of borrowers. It should also monitor any complaints received from disgruntled applicants. A bank might also consider reaching out to organizations that assist minority-owned businesses or businesses in low- to moderate-income areas to determine whether there are businesses they are aware of that need PPP assistance (at the time of the writing of this article, there was still funding remaining in the PPP program, so it is not too late to make such efforts). The bank should document such efforts so that this information can be provided to examiners if necessary to evidence a proactive approach to assisting all businesses.
BSA Compliance Risk
Another regulatory risk banks should be aware of is BSA compliance. The SBA Interim Final Rule and FAQ provided some relief from BSA requirements with respect to existing customers for which the bank had previously obtained the necessary BSA beneficial ownership information. For example, FAQ #18 states that if a PPP loan was being made to an existing customer and beneficial ownership information had been previously verified, the bank did not need to reverify the information. BSA compliance risk is especially relevant with respect to new customers of the bank receiving PPP loans. Banks can mitigate this risk by performing a quality control check on each PPP loan file to ensure the necessary information is in the file or a note is included in the file confirming that beneficial ownership information had previously been received and verified for the borrower. BSA compliance takes on extra importance since it is one of the four underwriting requirements from the SBA, and failure to comply could lead to SBA denying its guarantee.
PPP Program Compliance Risk
In addition to SBA review, the banking agencies may also look at PPP loans during their on-site examination for compliance with program underwriting requirements. Therefore, as explained above, banks should ensure their PPP loan files contain the necessary documentation evidencing that all four PPP underwriting requirements were satisfied.