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Financial firms contend with rising risk from changing U.S. COVID-19 stimulus program - Reuters Regulatory Intelligence

May 15, 2020

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by Richard Satran

Participants in U.S. COVID-19 stimulus programs are struggling with mounting compliance concerns and confusion over frequent guidance changes that pose significant regulatory and reputational risk. Some firms have limited their involvement or avoided the programs for fear of being burned.

In shifting policy moves, the Treasury Department has alternated between open handed offers of stimulus funds with “flexible” rules and promises to crack down on fraud with “serious consequences.”

The agency this week was doing both. It eased rules and limited liability for small borrowers on Wednesday but held to a Thursday deadline for larger public firms to return non-compliant loans or face what Treasury Secretary Steven Mnuchin termed “serious consequences.”

The Treasury chief has acted in the role of coordinating the $670 billion Paycheck Protection Program, or PPP, with the Treasury Department heading policy and the Small Business Administration (SBA) dispensing funds. Mnuchin also must coordinate with the White House, lawmakers and the Federal Reserve in the larger role of reviving a locked down economy. 

Fraud protection arose as a top concern after the SBA rapidly approved $350 billion in last month's initial funding tranche, in what appeared to be a "no-strings attached" policy. This led to stark warnings over fund misuse and confusion for financial firms' compliance and risk officers. Concern that aggressive oversight might expose them to fraud charges, borrowers in need have been slower to claim funds in a second, $320 billion round of funding now underway. About $100 billion of that amount has so far been claimed after three weeks. Funds were exhausted in 13 days in the first round.

The Treasury's effort to claw back funds from initial borrowers has also raised concern over the risk of participating in PPP among both lenders and potential borrowers. The Treasury's call for public firms to return funds under an amnesty has gone largely unheeded, with two-thirds of loan recipients ignoring the offer when it expired last week.

The safe haven period was extended a week and those results have yet to be seen. Borrowers have faced the difficult decision of whether to return already-approved funds or face possible action by the program's enforcement unit, headed by a dedicated inspector general coordinating with other U.S. authorities.

The U.S. Securities and Exchange Commission is also scrutinizing the program. It asked public companies that received emergency loans to prove they were qualified for the government funds and made consistent representations to investors about their need for the aid, two people with knowledge of the request told Reuters on Thursday.

Participation risk in PPP loans

The Treasury amnesty was offered for firms that had made faulty applications. In accepting the amnesty offer, borrowers were held to be acknowledging errors in their applications. The SBA has said such firms will avoid penalties by the agency, but legal advisers said it left those who returned loans exposed to liability from other regulators or private actions.

Risk professionals from the start of the PPP implementation have raised flags about the risk of participating in a government funding program with vague guidelines. The money was rushed out into the market without, as Mnuchin said in public comments, "any need for due diligence" by participating lenders. Borrowers faced a risk of False Claims Act violations for any inaccurate supporting documents on their loan applications. The borrowers were also required to request loans based on their own projections of the amount of money they would need to remain going concerns, in an economy fraught with unknowns.

The PPP program had utilized the SBA as a way to carry out fiscal stimulus across the entire economy, an unfamiliar role for an agency not set up to handle a large-scale funding program in a matter of weeks. But the light, flexible rules needed to get the fast-track approvals to borrowers did not last long after the launch; the Treasury Department quickly responded to charges that the lack of control enabled favoritism and potential fraud. The result has been a series of rules issued after the funds were approved.

Treasury eases demands for small borrowers

In the latest such change, the Treasury on Wednesday, just days after vowing stern measures for loan discrepancies and fraud in the PPP program, told small-scale borrowers -- those seeking less than $2 million -- that their applications would be considered qualified and would not be sent for "administrative enforcement or referrals to other agencies" even if suspect loans were identified. They would also be given a chance to return funds disqualified in audit work or loan review that pointed to unsupported claims.

Mnuchin held firm in demanding that public companies return loans that were approved but later questioned as ineligible. The program used the SBA’s size guidelines – usually preventing firms of 500-plus employees from SBA assistance -- but broad exceptions to the rule allowed 400 publicly traded firms to receive funds.

The shifting guidance and demand for repayment of funds awarded to public companies, came after an uproar over their use of SBA funds while smaller firms lost out. Some of the borrowers, such as Shake Shack, returned  the funds but complained openly over being singled out for loans that were qualified. The company cited reputational, not legal reasons, for giving funds back. But hundreds of others have held on and recent bankruptcy filings by large companies including J.Crew and Neiman Marcus, showed public ownership and size provide no protection from the pandemic.

Inconsistencies, sudden shifts at the top sow confusion

Legal and compliance professionals who have worked closely with the SBA said they saw signs of confusion and internal disputes inside the agency over the way the program was being carried out. With the pressing need to move quickly to help firms headed for collapse, some revisions were not surprising, although the agency staff, many working remotely, have felt stressed by the many shifts in program direction.

Some complained privately, said lawyers with contacts inside the program, over policy decisions being overridden by political considerations. Lawmakers even in normal times keep a close watch on the SBA, which constituents in home districts consider a major concern. In the pandemic, the tensions have boiled over as a major focus of media coverage.

Asked at a recent coronavirus briefing why borrowers were being pressured to return previously approved funds and banks were being criticized for making the loans that appeared to meet requirements, U.S. President Donald Trump said, “They’re supposed to do it according to not only criteria, but according to what we think is right.”

Seeking "clear guidance and sure footing"

“It has been difficult to find clear guidance and sure footing, even before the most recent government warnings,” said the law firm of Greenberg Traurig LLP in a client note. The law firm counted eight formal Interim Final Rules for the $2 trillion CARES Act and 14 updates to the Small Business Administration's frequently asked questions page on the PPP.

The frequent shifts in policy have made finance firms wary of U.S. regulators’ promises of safe havens or eased requirements during the pandemic. The power of any single federal agency to provide such relief has always included uncertainty since there is risk from other U.S. regulators, state authorities and private lawsuits filed with courts.

"This is a wholesale distribution of trillions of dollars to tens of thousands of users in a short period of time that has never been seen, and with a disorganization that exposes people to theft and fraud on a scale we would never have thought imaginable," Simon Moss, chief executive officer of fintech fraud detection firm Symphony Ayasdi AI LLC said in an interview. "This is the creation of a whole new asset class in which we do not understand the risk; that makes existing KYC (know your customer ) pointless."

In addition to such fraud risk, large banks faced sharp criticism from top SBA officials for what they called their slowness to participate in the initial stages of the loan programs by arranging loans for applicants. They later faced criticisms for taking on a disproportionate share of the lending, in aggressive efforts to claim the funds for their clients.

“It’s extremely challenging when you have so much conflicting information coming from the same source to decide what to do in these situations,” said Theresa Bevilacqua, a partner at the law firm Dorsey & Whitney LLP.  “It may be you have done nothing illegal and have made a successful claim but have to defend it, and also fight a PR battle at the same time, and that can be costly. So some people just returned the funds to avoid all that.”

Small number of loans win largest attention

Bank loans to public companies accounted for less than 1% percent of total PPP loans but the lion’s share of outrage. The Treasury Department assured lenders that the borrowers would be accountable for certifying the validity of the claims. But later, Treasury chief Mnuchin suggested that the review of eligibility was a shared responsibility and that banks “should have done that.”

Mnuchin, in another interview, criticized the large banks for favoring their existing large clients with loans, while the banks saw their actions as a commitment to serve client needs in crisis.

“Now, there were some banks early on who put things up on their website and prioritized their customers,” Mnuchin said. “We immediately told them that was wrong. They took it down.”

While the treasury secretary reaffirmed that banks would not be held liable for the content of the loan applications, his comments were followed by class-action suits based on the same complaint. Lawsuits were filed against Bank of America, Wells Fargo, JPMorgan Chase and U.S. Bank, accusing them of putting their clients ahead of other loan applications.

In another warning shot that banks were at risk, Wells Fargo & Co said in regulatory filing that it had received "formal and informal inquiries from federal and state governmental agencies regarding its offering of PPP loans.” The notification took on added significance since the bank was already under Federal Reserve supervision due to its 2016 sales abuse scandal.

Regulators warnings send a chill over loan uptake

Large banks have continued to work within the program, although at a much slower rate than in the first round. Small banks have handled 90 percent of applications by number, according to SBA data. On the other end of the spectrum, small borrowers have shown less interest in seeking the loans, and applications have fallen off sharply in round two.

Warnings of aggressive reviews for fraud may have chilled those who have never used banks for financing their operations. SBA data shows that 44 percent of small companies have no banking relationship outside of checking and deposits accounts.

Rohit Arora, chief executive officer of Biz2Credit, a small business lending consultancy, said the drop in applications reflects the regulatory risk that has hit the pool of potential applicants. The decline in applications also reflected less willingness to seek funding than in the first time, when the funds were seen addressing a short-term concern. But the slowdown in the second wave of funds reflects concern that short-term, forgivable debts under the program will be converted to longer term loans that under PPP rules must be paid back. Under the program PPP loans are forgiven if firms keep payrolls intact at pre-pandemic levels for eight weeks but become low interest loans for those that do not.

“There is a fear that if you default it will be viewed as a fraud, and that you will never be able to get another SBA loan again,” he said. “They figure they will just ride it out and go on hiatus rather than go deep into debt that will be there in the future. And they don’t want to come out of this with debt they will be paying when the economy reopens.”