By this point, eligible small-business clients have likely already received and spent their Paycheck Protection Program (PPP) loans. Now that the funds have been spent, most are turning their attention toward the Small Business Administration (SBA) forgiveness process — and many don’t like what they see.

SBA guidance on loan forgiveness has been spotty, and many important rules (and rule changes) were provided only after the fact, creating a huge risk for many business owners who were counting on both the loans and loan forgiveness to help them get by. The fact that the SBA has six years to challenge a business’ right to forgiveness makes the situation even more unstable for many.

Insurance companies haven’t overlooked this risk. A newly emerging class of PPP loan insurance could provide the solution for small-business clients looking for ways to mitigate their potential exposure down the line — but advisors need to pay close attention to this extremely new coverage option to make sure clients know what they’re getting into.

PPP Loan Qualification & Forgiveness: The Risk Factors

As mentioned, the SBA has a six-year period to challenge PPP loan eligibility. The SBA could launch an audit during the loan term, or as far out as six years after the loan had been forgiven. For many business owners, six years of financial insecurity would hinder their ability to grow and enter into valuable transactions with confidence.

Related: PPP Loan Recipients Are Lawyering Up

To qualify for PPP loan assistance, small-business clients were required to provide certain certifications at the outset. At the time of the loan, the business owner was required to certify that current economic uncertainty made the loan request necessary to support the ongoing operations of the business (i.e., that the loan was “necessary”).

The SBA also required borrowers to consider alternative sources of liquidity before applying for the loan. They were required to consider sources that would have been sufficient to support ongoing operations without being significantly detrimental to the business. The terms of this requirement arguably remain vague to this day.

Loans were only technically available to business owners with 500 or fewer employees. However, complex rules regarding affiliated parties created confusion for many — and the SBA only provided its interpretation of the requirement after many businesses had already completed their loan applications.

Misrepresentations in the application process — even if unintentional — could result in imposition of both fines and treble damages. Unfortunately, the SBA guidance has been released in stages over time, and we don’t know much about plans for audits or enforcement of the guidance received to date. This creates a very real risk that the rules will be interpreted unfavorably for business owners in the future.

PPP Loan Insurance Basics

PPP loan insurance is a completely new product that will likely develop more fully in the coming months. In general, insurance coverage would kick in if the SBA successfully challenged the small-business client’s right to receive the loan and later required repayment. Insurance coverage does not currently seem to be available to cover general situations where the SBA rejects the loan forgiveness application — unless the business owner was deemed ineligible for the loan from the start.

Coverage would equal the loan principal amount plus interest and penalties. It’s also possible that the insurer would cover the cost of defending the business owner throughout the SBA challenge.

Of course, business owners would only be entitled to coverage for good-faith mistakes in the process — if the loan was actually obtained fraudulently, the insurer would not provide a payout.

Clients who borrowed at least $2 million would likely find the most value in PPP loan insurance. SBA audit of smaller loan amounts is much less likely given the safe harbor threshold released earlier this year. Unfortunately, like much SBA guidance, the safe harbor was released after the fact and deemed to apply retroactively — and it seems entirely possible that the SBA could retroactively reduce the threshold in future guidance.

Clients who are interested in PPP loan insurance should expect the insurance company to conduct a thorough review process. The carrier will look into initial eligibility, the borrower’s certifications and how the pandemic impacted the client’s business generally. Clients should be advised to cooperate fully and ensure that any statements made in the process are accurate so that the insurance company doesn’t have any reason to avoid providing coverage.

Conclusion

Small-business clients who are interested in learning more about PPP loan insurance should be advised to pay attention to the fine print. Notably, coverage does not seem to apply if loan forgiveness is denied because the client spent the funds on impermissible expenses. Clients should be advised that the coverage is new and will likely continue to evolve — and that more extensive risks might be covered in the future.

— Related on ThinkAdvisor:

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