American Rescue Plan Act: Aid for Small Businesses and Nonprofits with ARP/CLFRF

Community and Economic Development – Blog by UNC School of Government

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American Rescue Plan Act: Aid for Small Businesses and Nonprofits with ARP/CLFRF

By Tyler Mulligan

Published October 4, 2021

The American Rescue Plan Act of 2021 (ARPA) is a wide-ranging law that provides federal funding in areas ranging from child care to higher education to community service to relief for shuttered venues to a restaurant revitalization fund. Separate from those programs, one component of ARPA distributes Coronavirus State and Local Fiscal Recovery Funds (“CLFRF”) to state and local governments for the purpose of responding “to the public health emergency with respect to the Coronavirus Disease 2019 (COVID–19) or its negative economic impacts, including assistance to households, small businesses, and nonprofits, or aid to impacted industries.” (Part 8, Subtitle M of ARPA).

Temporary rules governing the use of CLFRF have been promulgated by the U.S. Department of Treasury (“Treasury”) through an Interim Final Rule (IFR), codified at Part 35 of Subtitle A of Title 31 of the Code of Federal Regulations. In an “explainer” on the IFR, Treasury confirmed that “Funds used in a manner consistent with the Interim Final Rule while the Interim Final Rule is effective will not be subject to recoupment.”

It is possible that the actual final rule, to be promulgated at some later date (possibly later in 2021), will allow for funds to be expended for a wider range of programs or services. For that reason, some local governments are engaged in planning but are waiting for the final rule before making irreversible expenditure decisions. Other local governments may feel comfortable moving forward with expenditures, so long as the funded activities fall squarely within the guidance contained in the IFR. This post, in order to remain within the safe harbor of the IFR “explainer,” will examine only those programs or services that are explicitly mentioned in Treasury guidance. [UPDATE January 2022: Treasury’s Final Rule has been released and has not changed the legal conclusions in this post.]

The mere fact that a particular use of CLFRF is approved in the IFR does not mean a North Carolina local government possesses legal authority to engage in that activity. As Professor Kara Millonzi explains in an earlier post, all local government activities must also comply with state law requirements. Where federal law and state law conflict with each other, the most restrictive rule must be applied. This is important, when considering aid for small businesses and nonprofits, because Treasury guidance allows CLFRF to be used for a broader array of activities than North Carolina local governments can legally undertake.

Before analyzing how to use CLFRF to aid small businesses and nonprofits, it should be noted that other programs created by ARPA and its predecessor, the CARES Act, continue to provide significant direct aid to small businesses and nonprofits. Examples of federal aid include the Paycheck Protection Program (initially provided as loans, now being forgiven by the federal government in whole or in part), Emergency Injury Disaster Loans (with significant amounts being granted outright without repayment required), Shuttered Venue Operators Grants (for museums and theaters), and the Restaurant Revitalization Fund (for restaurants, bars, bakeries, and the like). The federal government administers these programs and makes disbursements directly to businesses. The generous federal aid programs described above reached even the smallest firms as explained by business school faculty here. Furthermore, the economy has experienced extraordinary economic growth during the first half of 2021, so some small firms have prospered.

Local governments today may be weighing the legal risk, regulatory burden, and practical complexity of providing aid to private firms a bit differently than they did at the outset of the pandemic. There are other eligible uses of CLFRF, such as long-term strategic investments in public infrastructure. CLFRF can be used to fund water and sewer facilities, affordable housing, and public parks and gathering spaces, all of which might be a higher priority in some communities than adding an extra layer of local aid on top of federal aid that has already been provided to private firms.

Nonetheless, some local governments are still exploring the possibility of devoting a portion of their CLFRF to direct financial aid for private enterprises. This post describes the legal requirements for doing so in North Carolina. The analysis begins by examining North Carolina law, which is far more restrictive than the federal rules imposed for CLFRF. After explaining state law, federal guidance on CLFRF will be examined to determine how North Carolina local governments can use the funds to aid private enterprises.

North Carolina Law

North Carolina Legal Authority to Provide Direct Financial Aid to Individuals

To understand North Carolina law on aiding private enterprises, it is helpful first to understand state law on aiding individuals. The North Carolina Constitution, the law of the land in this state, tells us that it is “one of the first duties of a civilized and a Christian state” to aid “the poor, the unfortunate, and the orphan.” In other words, it is always constitutionally permissible to provide direct aid to individuals in need. For example, the North Carolina Supreme Court has authorized loans for education for those “of slender means,” State Education Assistance Authority v. Bank of Statesville, 276 N.C. 576 (1970); loans for veterans to purchase homes, Hinton v. Lacy, 193 N.C. 496 (1927); provision of residential housing for sale or rental to persons and families of lower income, Martin v. N.C. Hous. Corp., 277 N.C. 29 (1970); and loans for persons of low and moderate income to acquire housing, In Re Denial of Approval of Bonds, 307 N.C. 52 (1982).

A local government cannot engage in any activity unless it has statutory authority to do so. In the case of aiding individuals in need, existing statutes authorize cities and counties to establish “community development programs” to provide for the “welfare needs of persons of low and moderate income.” G.S. 160D-1311(a). There are two important points to note about the statute: (1) a means test is imposed such that recipients of welfare aid must qualify by income, and (2) the reference to “community development programs” refers to federal programs, such as Community Development Block Grants (CDBG), which provide funding for activities that benefit low income persons. CLFRF is not a federal community development program per se, but it seeks to achieve many community development goals, so it is reasonable to rely on that statute for creating CLFRF programs. The statute grants authority for activities such as providing safe and decent housing for persons of low income; construction of community facilities for the benefit of low-income persons; and training programs for the unemployed.

There is no North Carolina case law regarding disaster aid. In the absence of case law, the North Carolina Attorney General authored a formal opinion in 1999 regarding the General Assembly’s constitutional authority to provide disaster aid to individuals and concluded that it was permissible. The Attorney General noted that it is a “first duty” to aid the “poor” and the “unfortunate,” and concluded that aid to individuals in need can serve a public purpose under the North Carolina Constitution, provided the program is properly tailored to address the immediate emergency.

North Carolina Legal Authority to Provide Direct Financial Aid to Businesses and Nonprofits

Providing aid to a business or nonprofit organization is an entirely different matter from aiding “poor” and “unfortunate” individuals. For one thing, after widespread government bankruptcies followed the collapse of quasi-public railroads in which governments had invested, state constitutions across the country were intentionally amended to prevent aid to private enterprises. In the late 1800s, “public purpose” and “gift” clauses were enacted to avoid future entanglements with private enterprise. Those clauses reflect the national rule to this day. Osborne M. Reynolds, Jr., Local Government Law 515 (4th ed. 2015) (“Gifts of property by local governments—at least to private individuals—are generally banned by statute or as a matter of common law; any transfer of municipal property must be supported by some reasonable compensation or benefit in return.”); John Martinez, 3 Local Government Law § 21:7, at 21-25 (2d ed. 2017) (“Local government property cannot be conveyed to a private party without adequate consideration, for to do so would constitute an improper gift of public property or the granting of a subsidy contrary to state constitutional constraints.”).

Specifically in North Carolina, the state constitution requires all expenditures of public funds to be “for public purposes only.” In addition, no private entity may receive “emoluments or privileges” (gifts) unless a public service is provided in return. Under North Carolina’s “exclusive emoluments and privileges” clause, a local government isn’t even allowed to make a donation to a charitable nonprofit entity. See Professor Frayda Bluestein’s blog post on the topic here. A local government can enter into a contract with a private entity and pay that entity a reasonable price for a valuable public service (such as paying a business to repair the roof of a public building or paying a nonprofit to provide homelessness prevention services), but the government cannot make a gift or donation to a private entity.

North Carolina courts have stated in multiple decisions that “direct state aid to a private enterprise, with only limited benefit accruing to the public, contravenes fundamental constitutional precepts.” Maready v. City of Winston-Salem, 342 N.C. 708 (1996). This should be axiomatic to local government attorneys. If it were permissible for governments to make grants or donations without requiring services in return, then legal requirements governing property conveyance at fair market value could be worked around. Grants could be used to undermine uniformity of taxation as classes of grant recipients could receive the equivalent of tax refunds. Utility law requirements about treating similarly situated customers the same could easily be avoided. Procurement rules and the outcomes of bidding processes could be nudged up or down by offering grants to preferred vendors. In addition, government is not permitted to engage in private business. See Mitchell v. North Carolina Ind. Dev. Fin. Auth., 273 N.C. 137, 156 (1968) (stating that “it is not the function of government to engage in private business”); Nash v. Town of Tarboro, 227 N.C. 283 (1947) (holding it is not a public purpose for a town to own and operate a hotel). State law, rooted in longstanding constitutional principles, contains a carefully constructed web of requirements and prohibitions designed to prevent direct government aid to private enterprises.

For an expenditure to serve a public purpose and not amount to an unconstitutional gift, the expenditure must meet a two-part test. First, the activity must be reasonably connected to a legitimate aim of government. Second, the ultimate gain must be the public’s, not that of an individual or private entity. Under this test, even loans to businesses have been denied. Mitchell v. N. Carolina Indus. Dev. Fin. Auth., 273 N.C. 137 (1968) (industrial development bonds not a public purpose); Stanley v. Dep’t of Conservation & Dev., 284 N.C. 15 (1973) (financing for pollution control not a public purpose). In 1996, the North Carolina Supreme Court created an exception to the general rule when it determined that business location incentives serve a public purpose when a business promises to create substantial “jobs and tax base” that “might otherwise be lost to other states.” Maready v. City of Winston-Salem, 342 N.C. 708 (1996). Most disaster relief programs don’t involve creation of substantial jobs and tax base that “might otherwise be lost to other states,” and North Carolina courts haven’t created an exception for disaster relief in the same way that they created an exception in Maready for business location incentives.

However, there is reason to believe that a disaster loan program for businesses would meet the two-part legal test for public purpose. For the first part of the test, disaster relief for those in need is, in general, a legitimate aim of government; provided that the program does not impermissibly compete with private lenders and is tailored to address the immediate emergency. The second part of the test, ensuring that the public purpose predominates over private interests, is probably achieved when a loan program is the relief mechanism. The public benefit is achieved because a loan with flexible collateral and payment terms will keep the business afloat in the short-term, allowing the business to repair damage, hire back its employees, and spread any losses over future years. A requirement for a business to hire unemployed workers would place the program on even more solid footing, because the focus of the program would be aiding needy individuals, rather than aiding a private firm. The public purpose would predominate because, ultimately, a business owner would take only so much of a (properly structured) public loan as the owner needs after accessing commercial loans, and the private interests would be minimal because the loan gets paid back.

The North Carolina Attorney General was asked whether the state could legally offer “low-interest loans” to businesses adversely affected by a disaster. In a 1999 formal opinion, the Attorney General performed the two-part public purpose test, and in particular examined the second part regarding whether the public purpose predominated over private interests. The Attorney General determined that a “low-interest” loan program would likely be upheld, so long as it was tailored to address the emergency situation. The opinion offered an example of tailoring, saying that the General Assembly should limit the loans only to businesses (1) that “suffered substantial damage” due to the disaster and (2) that were “not otherwise fully compensated” for that damage. (An excellent review of the AG opinion appears in the General Assembly’s bill draft summary for the state’s pandemic loan program for small businesses.)

One concern in the current crisis is that businesses have not suffered physical “damage” from COVID-19, and as noted above, many businesses and nonprofits have already received substantial aid from the federal government. And there are other sources from which a business may have been compensated (such as insurance, as reported here). An advantage of a loan program in this situation is that a local loan can be structured to ensure that the local loan is a last resort for a business—that a business would prefer to access federal or private loan programs before resorting to a local government loan. Advice on structuring a loan program to achieve this result, in addition to avoiding competition with commercial lenders, is described later in this post.

What about grants for private enterprises (or loan forgiveness), rather than loans?

CLFRF, according to federal guidance, may be used for “loans or grants to mitigate financial hardship [or] to implement COVID-19 prevention or mitigation tactics.” (Loan forgiveness is merely a grant provided later in time and is therefore equivalent to a grant.) Does it matter that federal regulations allow CLFRF to be granted to private entities? No. Regardless of what Treasury guidance authorizes, state law controls whenever funds are deposited into a local government account, as is the case for CLFRF. NC Const. Art. V Section 7(2).

Recall that North Carolina courts will evaluate the public purpose of an expenditure by conducting a two-part test. The two-part test is the same described earlier for loan programs, except that in a grant program, private interests are far more substantial—a business never pays back a grant, even if the business ultimately recovers and could have paid it back. Thus, grant programs are not permissible because they cannot pass the two-part test; the public purpose is essentially the same, but private interests are for more substantial. The only exception is business location incentives that are “parallel” to the Maready case described earlier, where incentives are necessary because substantial jobs and tax base “might otherwise be lost to other states.”

Demand for a grant program is no indication of public benefit nor financial need. A rational business will always seek a grant, so a grant program or other subsidy program will be over-subscribed even if applicant businesses don’t need it (as seen with COVID-related federal grant programs).

In an emergency situation, however, could a business grant ever pass constitutional muster? A possible approach is suggested in federal community development regulations, so it is not binding on North Carolina courts. That approach, theoretically, would authorize grant aid only if necessary to enable a subsistence microenterprise to aid persons in need. In this construct, loans and minimal grants would be necessary together in an emergency to stabilize a microenterprise to enable it to help persons in need, namely to hire the unemployed or to avoid loss of employment for low-income persons and sole proprietors. A very small grant might be required because a subsistence microenterprise earns low revenue, making the owner “low income,” and would not be expected to grow its income over time. The stabilization of the microenterprise would be merely incidental to the primary focus of helping persons in need, which is a constitutional imperative.

The statutory authority would be G.S. 160D-1311(a)(2), which authorizes North Carolina cities and counties to establish “community development programs” concerned with “employment … and welfare needs of persons of low and moderate income.” As already noted, that statute was enacted to enable local governments to employ federal community development funding such as Community Development Block Grants (CDBG). If that federal program can serve as a guide, we know that whenever CDBG stabilizes a business for the purpose of aiding low income persons, administrators must perform underwriting to ensure the benefit for low income persons will be achieved and that the aid is necessary. A stabilization program would therefore confirm the following through underwriting:

• • Emergency situation will cause subsistence microenterprise to fail unless minimal grants are paired with loans for stabilization, and one of the following is true:
    • Enterprise failure will lead to unemployment of low income persons, and/or
    • Enterprise stabilization is necessary to allow enterprise to hire (or rehire) unemployed persons or low income underemployed persons.
  • After stabilization:
    • Enterprise has properly structured debt and equity (e.g., entity should receive loans only, until it reaches a certain debt capacity such as 1.15, which is the debt service coverage ratio used by the federal Small Business Administration (SBA));
    • Profits are not excessive (no more than necessary for stabilization); and
    • Enterprise will remain financially viable in order to deliver the promised benefit to low income persons.

Community Development Financial Institutions (CDFIs) are community-minded lenders that are well positioned to perform such underwriting on behalf of local governments. State and local governments may wish to partner with CDFIs following the guidance described in the following blog post: Local Government Emergency Loans for Small Businesses: Contracting with Financial Institutions for Loan Administration.

With state law explained, the result may be summarized.

Summary table of North Carolina law regarding aid to businesses and nonprofits

As a final note on state law, almost all of the limits described above are constitutional, not statutory. There is ample statutory authority for the activities described above. However, when a statute approaches a constitutional limitation such as the prohibition against exclusive emoluments (gifts), the statute must be applied by a local government in a constitutional manner. Even if the General Assembly were to enact an overly broad statute that purports to go beyond the limits of the state constitution, local government elected leaders and attorneys, who have sworn to uphold the state constitution, are obligated to apply the statute in a way that remains within the bounds of the constitution. North Carolina courts are also bound to follow the state constitution: “We have repeatedly held that as between two possible interpretations of a statute, by one of which it would be unconstitutional and by the other valid, our plain duty is to adopt that which will save the act. Even to avoid a serious doubt the rule is the same.” In re Dairy Farms, 289 N.C. 456, 465, 223 S.E.2d 323, 328-29 (1976) (citation and internal quotation marks omitted).

Federal Guidance on CLFRF

Can CLFRF be used to fund an aid or stabilization program for private enterprises?

As noted previously, where federal law and state law conflict with each other, the most restrictive rule must be applied. Thus, the pertinent question is whether an aid program or stabilization program, enacted in compliance with state law as described above, could be funded with CLFRF.

As a general matter, CLFRF is authorized only for purposes that “respond to the public health emergency or its negative economic impacts.” 31 CFR 35.6(b). Treasury guidance provides a “non-exclusive” list of eligible uses of CLFRF. For uses that are not explicitly mentioned in Treasury guidance, recipients must determine “whether a program or service responds to the negative economic impacts of the COVID-19 public health emergency” and “should assess the connection between the negative economic harm and the COVID-19 public health emergency, the nature and extent of that harm, and how the use of this funding would address such harm.” (IFR p. 10)

Fortunately, Treasury guidance (IFR p. 31; FAQ (7/19) Question 2.5) explicitly authorizes the use of CLFRF to provide assistance to “small businesses and non-profits,” including but not limited to:

• “Loans or grants to mitigate financial hardship such as declines in revenues or impacts of periods of business closure…
• Loans, grants, or in-kind assistance to implement COVID-19 prevention or mitigation tactics… and
• Technical assistance, counseling, or other services to assist with business planning needs.”

Treasury guidance encourages local governments to use additional criteria “to target businesses in need, including small businesses.” Such criteria could include “businesses facing financial insecurity, substantial declines in gross receipts (e.g., comparable to measures used to assess eligibility for the Paycheck Protection Program), or other economic harm due to the pandemic, as well as businesses with less capacity to weather financial hardship, such as the smallest businesses, those with less access to credit, or those serving disadvantaged communities.” (IFR p. 31) General economic development and workforce development programs are not eligible. (FAQ (7/19) Question 2.8)

Taking state law and federal guidance together, the following are minimum criteria for programs funded with CLFRF:

* For assistance with such analysis and program administration, local governments are authorized to engage consultants and even transfer CLFRF to pass-through entities. For more information, see discussion below: Can local governments partner with third parties to handle underwriting and administration of CLFRF programs?

** According to the Interim Final Rule (page 33), if industries other than “tourism, travel, and hospitality” are specifically targeted, the local government must make a finding regarding “whether [the negative economic] impacts were due to the COVID-19 pandemic, as opposed to longer-term economic or industrial trends unrelated to the pandemic.”

Finally, Treasury guidance imposes additional requirements for financial aid to private businesses:

“To facilitate transparency and accountability, the interim final rule requires that State, local, and Tribal governments publicly report assistance provided to private-sector businesses under this eligible use, including tourism, travel, hospitality, and other impacted industries, and its connection to negative economic impacts of the pandemic. Recipients also should maintain records to support their assessment of how businesses or business districts receiving assistance were affected by the negative economic impacts of the pandemic and how the aid provided responds to these impacts.” (IFR p. 34)

Can local governments partner with third parties to handle underwriting and administration of CLFRF programs?

Local governments should not underestimate the complexity of CLFRF administration. Most procurement and other regulatory requirements that typically accompany federal funds are also applicable to CLFRF. Treasury guidance states that CLFRF “as a general matter will be subject to the provisions of the Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards (2 CFR part 200) (the Uniform Guidance), including the cost principles and restrictions on general provisions for selected items.” (IFR p. 86, FAQ (7/19) Question 9.3) Additional explanation is provided in Treasury’s Compliance and Reporting Guidance (v. 1.1).

There are third parties, such as Councils of Governments (COGs) and Community Development Financial Institution (CDFIs), that have extensive experience with administration of federal funds, including for revolving loan funds. CLFRF can be transferred to these third parties so long as the original local government recipient continues to monitor and report on the use of the funds by the subrecipient. More specifically, FAQ (7/19) Question 1.8 addresses transfers to nonprofits: “A transferee receiving a transfer from a recipient under sections 602(c)(3) and 603(c)(3) [of ARPA] will be considered to be a subrecipient and will be expected to comply with all subrecipient reporting requirements.” See 2 CFR § 200.332 (Requirements for pass-through entities). “The recipient remains responsible for monitoring and overseeing the subrecipient’s use of Fiscal Recovery Funds and other activities related to the award to ensure that the subrecipient complies with the statutory and regulatory requirements and the terms and conditions of the award.” IFR p. 94

Treasury guidance also addresses regional cooperation. FAQ (7/19) Question 4.9 clarifies that local governments may pool resources for regional projects, and even allows for transfers to a government outside its boundaries, “provided that the recipient can document that its jurisdiction receives a benefit proportionate to the amount contributed.”

Can a local government transfer its CLFRF to a nonprofit to implement a grant-making activity that the local government is not permitted to undertake?

Could a local government simply turn funds over to a charitable nonprofit partner and let that partner issue unconstitutional grants to businesses? The answer is no for two reasons.

The first reason should be obvious. A nonprofit cannot use government funds to do something that the appropriating government is not permitted to do. Public funds remain subject to constitutional requirements even when appropriated to another entity. Briggs v. City of Raleigh, 195 N.C. 223 (1928); Dennis v. City of Raleigh, 253 N.C. 400 (1960).

The second reason is less obvious. Charitable partners are subject to similar requirements prohibiting financial assistance to businesses. The IRS says it quite succinctly: “A business is not an appropriate charitable object.” The IRS follows the same distinction that was discussed above under North Carolina law: aiding needy individuals is permissible, whereas aiding businesses generally is not.

Even in a disaster, the rules for charitable organizations are strict. IRS Publication 3833, Disaster Relief: Providing Assistance through Charitable Organizations, covers the topic. It draws on guidance that was provided to 501(c)(3) organizations following the September 11 attacks, when New York City was shut down and businesses were struggling.

Charitable organizations are clearly permitted to provide aid to individuals affected by a disaster, including “basic necessities, such as food, clothing….” The publication makes clear that the appropriate aid “depends on the individual’s needs and resources.” Once a victim’s immediate needs are met, further aid depends on “individual financial needs assessments.” Thus, even when individuals are bonified victims of a disaster, charities can address immediate needs but thereafter must assess financial need prior to disbursing aid.

The IRS publication directly addresses when it is appropriate to aid businesses in disaster areas. Basically, the focus of charitable assistance should remain on needy individuals. It might be permissible to aid a business in order to aid an individual (such as a sole proprietor who could lose their livelihood), but the focus remains on the individual and any benefit to the private business must be “incidental.” All of the following considerations were important in determining that aiding a business was acceptable:

• Businesses selected for aid were ones which “would hire unemployed or underemployed residents” (Rev. Rul. 74-587);
• Aided businesses would not likely locate or remain in the area without the charity’s assistance; and
• The aided businesses did not have adequate resources from their own assets, conventional financing, or insurance.

A charity that aids a business must make an assessment of financial need before disbursing aid to the business, and then once a business has been “restored to viability … further assistance from a charity is no longer appropriate.” The charitable organization is required to have “criteria and procedures in place to determine when aid should be offered and discontinued.” An assessment of financial need is critically important.

How much CLFRF may be used to fund loans?

The amount of CLFRF that may be used to fund loans depends on when the loans mature and whether or not the loan fund is “revolving.” In a “revolving loan fund,” all interest and principal payments made by borrowers are returned to the loan fund and eventually “revolved” back out to another qualifying borrower. Under current CLFRF accounting rules, CLFRF may be used only for the “projected cost” of loans. According to Treasury guidance (FAQ (7/19) Question 4.11), this results in three basic categories of loans:

1. Loans that mature by December 31, 2026 (the date by which unexpended CLFRF must be returned to the federal government pursuant to 31 CFR 35.5):
   • CLFRF may be used to fund the full amount of loans maturing during the CLFRF period of performance, but all interest and principal payments (including final payoff) will be considered “program income” and treated as “an addition to the total [CLFRF] award.” In addition, all such income is explicitly exempted from 2 CFR 200.307(e)(1), a provision in federal Uniform Guidance which would otherwise require the income to be deducted from the total award. Income received is subject to the same time restrictions as the original award and “may be used for any purpose that is an eligible use of funds under the statute and IFR.”
2. Loans that mature after December 31, 2026:
   • CLFRF may be used only for the “projected cost” of each loan, using an analysis of expected cash flows with a discount rate or using the Current Expected Credit Loss (CECL) standard. Once the projected cost is calculated and the CLFRF portion is determined, any income received thereafter is not subject to the restrictions of 2 CFR 200.307(e)(1) and local governments need not separately track repayment of principal or interest. These accounting rules are described in further detail in FAQ (7/19) at Question 4.11.
3. Revolving loan fund (in perpetuity):
   • CLFRF may be used to fund the full amount of a revolving loan fund in which all interest and principal payments are to be deposited back into the loan fund and revolved back out to new qualifying borrowers in perpetuity. The challenge is that eligible borrowers will dwindle over time, as it will become more difficult in later years to show that a borrower requires a loan to “mitigate financial hardship” related to COVID-19. Thus, the “projected cost” of the loans may shift over time, requiring the analysis described above for loans that mature after 2026. Revolving loan funds are explicitly mentioned in Treasury guidance and are consistent with Treasury’s expressed goal to encourage “funding uses … with long-term benefits for health and economic outcomes.” Thus, it is possible that Treasury will revise the guidance on revolving loan funds because Treasury’s Compliance and Reporting Guidance (v. 1.1), Part 1.D.9, states, “Treasury intends to provide additional guidance regarding program income and the application of 2 CFR 200.307(e)(1), including with respect to lending programs.”
     • UPDATE January 2022. Treasury provided no additional guidance in its Final Rule. In the Final Rule preamble, page 366, Treasury states: “The final rule maintains the treatment of loans from the interim final rule and subsequent guidance, as discussed above. This approach is consistent with the statutory Coronavirus State and Local Fiscal Recovery Funds, Frequently Asked Questions, as of July 19, 2021; https://home.treasury.gov/system/files/136/SLFRPFAQ.pdf.” Thus, the situation remains unchanged. A revolving loan fund might still be possible if it takes advantage of an automatic presumption that will still be true even after 2026. For example, the final rule offers a presumption that small businesses and nonprofits in a QCT are disproportionately impacted. See 31 CFR 35.6(b)(2)(iii). Local governments should consult with their attorneys and accountants to make a determination about how a revolving loan should be treated under the Final Rule.

Structuring a Loan or Stabilization Program

A loan or stabilization program should address the following elements as a minimum:

• Eligibility. Establish which private enterprises are eligible to receive the loan. See the criteria contained in the tables above. Note that a local government may not impose unconstitutional eligibility restrictions (such as race or religion) and must have a rational basis for any eligibility restrictions it establishes.
• Loan Structure.
  • Maximum loan amount. Determine the maximum loan amount available to each borrower. Banks often set the maximum loan amount based on the value of the borrower’s collateral. Local government lenders typically set relatively low maximums in order to conserve limited resources and assist more businesses.
  • Payment structure. Will the loan have a period of deferral (no interest or principal payments due, with interest rolled into the principal each month)? Will it have a period of “interest only” payments before the outstanding principal is converted into a fully amortizing loan? To view examples of different payment structures and to download a model loan calculator (in customizable Microsoft Excel format) created by the School’s Development Finance Initiative (DFI), see this prior blog post, Local Government as Lender.
  • Amortization period. An amortizing loan is familiar to most individuals who have a home mortgage. An amortizing loan involves the borrower making a predetermined scheduled payment over a period of years that will pay interest and eventually reduce the principal amount to zero. Many commercial loans amortize over a ten year period. SBA disaster loans are amortized over a 30 year period (similar to home mortgages). The longer the amortization period, the more manageable for the business to make regular payments.
  • Maturity date. The borrower is required to pay back the loan in full on the maturity date. Regardless of the payment structure and amortization period, a loan could still have a short-term maturity date, such as three or four years, with the expectation that the borrower must find new financing in order to satisfy or “take out” the short-term loan. The loan documentation should include an acceleration clause to “call” the loan in the event the federal government demands the funds to be returned prior to the maturity date.
  • Appropriate “risk-adjusted” interest rate through entire loan term. Interest rates are set according to each loan’s risk profile. More risky, unconventional loans carry a higher interest rate. Risk is determined by examining borrower’s collateral and credit rating, debt coverage ratios, loan maturity, amortization, and payment schedule (monthly, annual).
• Security or collateral. Commercial loans are typically secured with some form of collateral provided by the borrower. Upon default by the borrower, the lender can sell the collateral and use the proceeds to offset any amount still owing on the loan. Sometimes collateral will have multiple liens for multiple loans, and each lien has a specific priority. The first lien has highest priority—if the collateral must be taken and sold to satisfy a loan in default, the first lien gets paid first when the collateral is sold. A second lien has second priority—meaning, it gets paid with anything remaining after the first lien is satisfied. A loan with a second lien thereby carries higher risk than a loan with a first lien and should carry a higher interest rate (approximately 100-300 basis points higher) than the loan with a first lien. Unsecured loans have no collateral requirements and the lender holds no lien; therefore the lender has no recourse in the event of default. Unsecured loans are so risky as to be nearly equivalent to outright grants, raising questions about their constitutionality. Accordingly, local governments are advised to obtain some security, such as a deed of trust on real estate (Fannie Mae form here) or a UCC Financing Statement on personal property.
• Loan servicing considerations. Determine which agency will be responsible for tracking loans, collecting payments, sending default notices, and following up on collections. Check whether the local government already possesses this capacity in-house (such as utilities billing) or at a Council of Government. Should the local government need to contract with a loan servicer (as described in a post here), it will need to follow federal Uniform Guidance procurement regulations.
• Legal documentation. Every loan should be evidenced by a fully executed promissory note. An example of a promissory note utilized by the North Carolina Housing Finance Agency can be found here. Every loan issued by a local government should be secured with some form of collateral, such as a deed of trust (Fannie Mae form here) or a UCC Financing Statement.