Wall Street CARES!: Who Gets the Hidden Subsidies Under the CARES Act?
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This post first appeared on The Columbia Law School Blue Sky Blog on 15 April 2020 and also on the Oxford Business Law Blog on 8 May 2020
By Prof. John Coffee (Columbia Law School and ECGI)
The CARES Act was passed under intense pressure and with minimal transparency. The consequence of this opaque process is that there are some surprising windfalls. No criticism is here expressed of the act’s purpose, but Wall Street knows one thing about federal subsidies: Charity begins at home.
The centerpiece of the CARES Act is Section 1102’s “Paycheck protection program,” which will make available some $349 billion to be lent to small businesses in loans guaranteed by the Small Business Administration (“SBA”).[1] These loans will carry a very low 1% interest rate, and the expectation is that most of the loan will be forgiven in order to convince businesses not to lay off employees. Obviously, most everyone wants a loan that resembles free money.
But now comes the hidden detail that most have missed. A 1% loan hardly rewards the bank that makes it (even though the loan is risk free because of the SBA guarantee). To incentivize banks to make these loans, the CARES Act promises fees for processing these loans. Congress has authorized a sliding scale of fees, as follows:
- 5% for loans of $350,000 or less;
- 3% for loans of between $350,000 and $1 million; and
- 1% for loans of not less than $2 million.[2]
Although the SBA is authorized by the CARES Act to guarantee up to a $10 million loan, the SBA has indicated that it will not go above $2 million under this program. Hence, the “reimbursement” fee will be either 5% or 3%. Let’s assume that the average payment will be 4%. On this basis, if the full $349 billion is lent by the June 30 cutoff date for “covered loans” under this program, the total payment to banks would be around $14 billion (just for loans made to that point). This program is likely to be renewed and extended, so that this is just the initial payment. At least for lenders, this is a highly desirable subsidy at a time when M&A and IPO activity is likely to be way down or even nonexistent.
How much work is necessary to earn this fee? The SBA application is fairly short and will be largely filled out by the small business borrower. Banks have reported that the SBA’s computer system keeps crashing and that it can thus take an hour or more to enter an application manually. But does a couple of hours work by a low level bank officer really justify a 3% fee on a $1 million loan (or $30,000)? That’s nice work if you can get it.
Another provision in this same subparagraph (P) instructs the SBA’s administrator to pay the lender’s reimbursement fee within five days of the loan’s disbursement.[3] I expect that law firms would like their banking clients to pay their fees as promptly.
This high generosity to lenders is about what you would expect when the legislative process is opaque and Congress is likely to rely on “expert” lobbyists. But the next issue involves whether the subsidy to small business borrowers is being properly distributed. The loans are being made on a “first come, first served” basis, but borrowers must have a lender willing to sponsor them with the SBA. Sole proprietors are finding it difficult to get their bank’s attention.
Who is likely to be the most adaptable “small business” that will jump to the front of this new line? Some indications exist that hedge funds and private equity funds are eagerly seeking such loans (and they certainly have banks that will be happy to sponsor them). Few of them have more than 500 employees (which is the cutoff condition to qualify as a small business).
What evidence is there that hedge funds and private equity funds are lining up for this subsidy? Aksia LLC, an investment consultant to such funds and their investors, has sent out a much publicized “warning” letter to its clients, advising them that such funds would be viewed “negatively” by their investors and Wall Street.[4] Perhaps so, but Aksia noted also that the typical hedge fund could qualify for an SBA loan of up to $2 million. Appropriate as this warning is, the scorn of Aksia is probably not an effective deterrent.
Under the CARES Act, only the first $100,000 of an executive’s salary may be considered a basis for a qualified paycheck protection loan. But consider a hypothetical hedge fund with three employees making over $1 million each, two over $300,000, and one at $250,000. That adds up to $600,000, and secretaries, clerks and technicians could easily qualify this firm for a $1 million loan at 1%. Also, hedge funds pay notoriously high rents on pricey office space, and this expense also qualifies for a loan. Little is being done to audit or monitor these applications. As of April 9, the SBA announced that it had approved some 550,000 loans for a total of $141 billion.[5] That amount in roughly 10 days implies that little due-diligence is being done.
Worse than the loan being unjustified is the likelihood that it may be ultimately forgiven under §1006 of the CARES Act. The problem here is not just that poor taxpayers are subsidizing rich hedge funds, but that hedge funds and private equity firms have suffered no obvious decline in their business. Such firms thrive in volatile markets and now may see opportunities to invest in undervalued companies.
What then are the lessons to be learned (as Congress considers extending this new subsidy)? Three stand out: First, we may not need banks in this process at all. The government could directly advance funds to employers to cover payroll expenses. This would speed up the process, reduce unnecessary fees, and probably curb fraud (as the employers directly certify to the government their payroll and other eligible expenses). False statements to the government are criminal. Second, the subsidy should be paid only to firms that have suffered a significant decline in their revenues or earnings (this would likely exclude most hedge funds and private equity firms). Lastly, the need for the SBA to be at the center of this process seems doubtful. It is an inefficient agency that cannot likely scale up to the challenge. A better vehicle would be the IRS (which can better monitor and enforce).
ENDNOTES
[1] The CARES Act basically amends Section 7(a) of the Small Business Act (15 U.S.C. §636(a)). Section 1102 of the CARES Act (the Paycheck protection program)) will become Section 7(a)(3b) of the Small Business Act.
[2] See Section 1102 (P) (“Reimbursement for processing”), which will become §7(a)(36)(P) of the Small Business Act.
[3] This requirement is set forth in Section (P) (iii) of Section 1102.
[4] See Juliet Chung, “Funds Warned Not to Abuse SBA Virus Loans,” The Wall Street Journal April 10, 2020 at B-10.
[5] See Yoka Hayashi, “Small Business Owners Fret Over Delays,” The Wall Street Journal, April 11, 2020 at A-1.
John C. Coffee, Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.