Local Government Emergency Loans for Small Businesses: Contracting with Financial Institutions for Loan Administration

About the Author

Tyler Mulligan

Tyler Mulligan is a School of Government faculty member focusing on community development, economic development, public-private partnerships for revitalization, and development finance.

The COVID-19 public health crisis is giving rise to an unprecedented economic crisis. Economic activity across the nation has slowed considerably, and many small businesses—which were operating successfully only one month ago—are now struggling to survive. As their bills pile up but no revenue comes in, some businesses will run out of cash and be forced to shut down permanently. Business closures on a vast scale would likely inhibit a recovery for years after the current crisis subsides. The economy will rebound more quickly after the crisis if these small businesses keep their staff in place and are able to resume operations as soon as restrictions are lifted.

One way to assist small businesses during a cash crunch is to establish an emergency loan program. The federal Small Business Administration (SBA) offers a disaster loan product for this purpose, but the process takes 60-90 days (possibly longer in a time of heavy demand) for the SBA loan to be issued by a bank. Some businesses would be forced to lay off workers in the interim, and many businesses still wouldn’t have enough cash to remain solvent while waiting for the SBA loan.

This is where state and local governments come in; they can offer emergency loans during the intervening period. As explained in an earlier blog post, North Carolina local governments possess statutory and constitutional authority to offer small business loans and could fill the gap. However, the need is great and local governments may not have enough trained staff to run a loan program at the scale required. Fortunately, North Carolina is home to an array of community-minded financial institutions who know how to administer and manage small business loans. A number of those financial institutions have collaborated on a statewide emergency loan program. It is possible for local governments to contract with these and other third-party financial institutions for administration of a local government emergency loan program.

A properly structured loan program could avoid constitutional concerns related to public purpose and exclusive privileges, as described in an earlier blog post, and would enable a local government to support small businesses during a crisis. A team of SOG faculty (Crews, Houston, Millonzi, Mulligan) put their heads together to come up with two permissible models for contracting with a third-party financial institution (“3rd Party”) for management of an emergency loan program: (1) 3rd Party as administrator only and (2) 3rd Party with access to an account funded by the local government. This blog provides an overview of each model and then addresses general legal matters applicable to both.

The two models are described in the table below:

  3rd Party as administrator only 3rd Party can draw from account funded by local government
Overall Risk Posture Relatively lower Relatively higher
Approves loan program parameters Local government board Local government board
3rd Party access to local government funds No access. 3rd Party completes loan documentation and submits to local government. Local government official approves loan and disburses loan proceeds directly to borrower. Local government deposits funds into account to which 3rd Party has access. 3rd Party may withdraw funds to make loans. Withdrawals are governed by contract between local government and 3rd Party. See risk mitigation measures discussed below.
Bidding required for selection of 3rd Party administrator? No bidding required under state law (contract is a service contract)—verify whether local purchasing policy is more restrictive. No bidding required under state law (contract is a service contract)—verify whether local purchasing policy is more restrictive.
Loan agreement parties Local government is lender and loans directly to borrower. Promissory note and any collateral executed by borrower in favor of local government. (3rd party is not lender.) 3rd Party acts as lender. Local government fiscal control can be enhanced by requiring borrower to execute promissory note and collateral in favor of local government. See risk mitigation measures discussed below.
Provides customer service to potential borrowers during application process 3rd Party 3rd Party
Performs underwriting and makes loan recommendation 3rd Party 3rd Party
Approves loan that meets parameters and issues funds to borrower Local government official 3rd Party approves each loan in compliance with parameters established in contract between 3rd Party and local government. 3rd Party draws from government-funded account to disburse loan proceeds to borrower.
Timing of local government review Before issuing loan After 3rd Party issues loan and submits executed loan documents to local government
For loans that violate program parameters, should administrator be liable for reimbursing local government for full amount of improper loan? NO (local government approved loan and disbursed loan proceeds) YES (3rd Party approved loan and disbursed loan proceeds and therefore should be held responsible for errors)
Loan payments by borrower remitted to… Local government Local government or 3rd Party depending on risk posture of local government. See risk mitigation measures discussed below.
Who bears loss in the event of borrower default? Local government Local government
Annual reporting by 3rd Party required by statute? NO YES (G.S. 158-7.2)

Risk mitigation measures – risk of financial loss through borrower default

In both models described above, there is significant risk of financial loss through borrower default. That risk is inevitable and, frankly, expected in such an uncertain economic environment. There are ways to reduce the risk of financial loss, as described below, but these methods carry trade-offs for the success of the program.

  • Require borrowers to provide security or collateral as a condition of receiving a loan, as described in a prior post on local government emergency loans. However, keep in mind that imposing collateral requirements adds complexity to loan processing and could dissuade some businesses from participating. Local governments will need to strike the balance that reflects the risk they are willing to accept and then assign interest rates that reflect the security provided by the borrower. Unsecured loans involve greater risk for the lender and therefore carry higher interest rates as explained in an earlier blog post.
  • Require the 3rd Party to use some of its own funds (or “match”) with every loan that is issued. This ensures that the 3rd Party has “skin in the game” for every loan and will carefully consider each borrower’s creditworthiness. The trade-off with this approach is that the 3rd Party may seek to protect its own capital and be reluctant to loan funds to any but the most creditworthy borrowers, thereby undermining the goal of serving many businesses as quickly as possible.

Risk mitigation measures – risk related to fiscal control over funds

Another risk faced by local governments when contracting with a 3rd Party relates to how local government funds are managed, or fiscal control. This risk can be managed by establishing greater local government control over the loan program. A local government exercises the most fiscal control over a loan program and is best positioned to manage risk in the first model described above, in which the 3rd Party provides administrative support only and has no access to local government funds. However, for speed and efficiency, a local government may prefer to deposit loan capital into an account that can be accessed by the 3rd Party financial institution, reflected in the second model described above. The second model therefore carries greater risk related to fiscal control, but there are several ways for a local government to manage this risk:

  • Rather than depositing the available loan capital into an account controlled solely by the 3rd Party, establish an independent account in which the local government and 3rd Party both exercise control. To reduce risk even further, establish an escrow account in which an escrow agent releases funds only after it is satisfied that the 3rd Party has met the conditions set forth in an escrow agreement. The trade-off is that each additional layer of control for the local government reduces the speed with which the 3rd Party can issue loans.
  • Require borrowers to make loan payments directly to the local government, rather than to the 3rd Party, and execute loan documents and collateral documents in favor of the local government. The trade-off with this approach is that loan payments will go to the local government, rather than replenishing the loan capital account, and therefore funds cannot be “revolved” into another loan; however, the local government could, of course, make another appropriation to the loan program if it wishes.
  • Set a date in the contract by which the program ends and all remaining funds are returned to the local government, and allow the local government to shut down the program sooner at its discretion.

In any case, the 3rd Party must account for all local government funds as required by G.S. 158-7.2. The 3rd Party should also be required to provide all loan documentation to the local government, and the 3rd Party must fully refund the local government for any loan that was issued outside of the parameters established in the management contract between the local government and 3rd Party.

Time is of the essence: approval and statutory authority during an emergency

As explained in a prior post, several statutes provide authority for a small business loan program. The broadest statute is G.S. 158-7.1. Under that statute, a properly-noticed public hearing is required prior to approving the appropriation, as described in this blog post: Notice and Hearing Requirements for Economic Development Appropriations. Notice must be issued ten days prior to the public hearing.

A ten-day delay may be too long for businesses that are quickly running out of cash, so some local governments may want to approve the program immediately. To that end, a local government could, as a supplemental measure, also approve the loan program under the Emergency Management Act (G.S. Chapter 166A). However, the Emergency Management Act is not a perfect fit. There is no express authority for issuing loans to businesses—the text focuses on infrastructure and emergency services. Nor is there any case law suggesting that the Emergency Management Act authorizes loans to businesses. For a legal framework to evaluate emergency management powers in the absence of express authority, see Norma Houston’s blog post here.

Another drawback of relying on the Emergency Management Act to authorize a loan program: the basis for the program evaporates once the emergency ends. Thus, it is advisable to approve the program under G.S. 158-7.1 as well and comply with that statute’s notice and hearing process. The Emergency Management Act does not waive statutory requirements imposed by G.S. Chapter 158.

Geographic limitation

No matter which statutory authority (Chapter 166A or Chapter 158) that a city or county relies on to create a small business emergency loan program, both limit the geographic area in which loans may be issued.

Under the Emergency Management Act, counties exercise operational control over emergency management efforts within the county (G.S. 166A-19.15(a)). Cities are authorized to exercise emergency management functions within the city (subject to operational coordination by the county). (These management functions are not to be confused with the separate legal authorities of counties and cities to impose emergency restrictions and prohibitions under GS 166A-19.31 as described in Norma Houston’s blog post here.)

G.S. 158-7.1(a) authorizes appropriations for “economic development purposes,” but findings must be made that the appropriation will benefit the “city or county.” G.S. 158-7.1(b) authorizes real property acquisition only within a county, reinforcing the county focus. It must be acknowledged that city and county residents are sometimes employed outside of the county, so arguably loans could be made to those outside businesses. However, demonstrating the inter-county benefit would require burdensome documentation. In a crisis, it may be simpler to restrict lending to business activities in the county.

With limited capital available for loans, which borrowers receive priority?

Objective criteria and priorities should be established to ensure that the process is fair for determining who may receive a government-funded loan. First-come, first-served loan programs could raise questions, particularly if constitutionally protected classes (race, religion, etc.) are disadvantaged by the process. One can imagine an issue, for example, with loan administrators being located in some communities and not others, or applications being online only and therefore less accessible to certain populations. It is advisable to articulate a strategy for reaching historically excluded and legally protected populations—including for programs managed by a 3rd Party.

Initial “no payment” periods are appropriate; zero interest rates are not

It is important for an emergency loan program to give borrowing businesses several months during which no payments of any kind will be collected. My prior blog post suggested a “no payment” period of 6-12 months might be necessary to help a business weather a crisis. A no payment period is important because a business with reduced revenue may not be able to make loan payments during the crisis. However, this doesn’t mean that the loan should carry “zero interest” during the no-payment period. Zero interest has two problems as explained in my prior post. First, it places a government lender in direct competition with banks, which also offer short term loan products. Second, the forgone interest is essentially an unconstitutional gift to the borrowing business. To avoid constitutional issues, a local government loan should carry a risk-adjusted rate of interest at all times. Interest will accrue during the “no payment” period, but it is not paid during that time. At the end of the “no payment” period, the deferred interest is rolled up into the loan.

Emergency powers do not override statutes and the state constitution

It is probably clear from the discussion above that emergency powers do not override other statutory and constitutional requirements, a point made by emergency management expert Norma Houston in a blog post here. A local government must rely on statutory authority for its actions and must comply with the state constitution at all times.

Finally—be wary of conflicts of interest

Since emergency powers do not – and cannot – override other statutory requirements, cities and counties that choose to create a small business emergency loan program must remain mindful of the prohibition against self-benefiting under a public contract.  G.S. 14-234 prohibits a public officer or employee who is involved in making or administering a contract from receiving a direct benefit under the contract.  A direct benefit includes having more than 10% ownership interest in the entity that contracts with the local government or receiving income or commission directly under the contract.  The prohibition also applies to spouses of officers and employees who are involved in making or administering the contract.  A violation of GS. 14-234 is punishable as a Class 1 misdemeanor and renders the contract void by operation of statute.  Because a loan agreement is a form of contract, the restrictions of G.S. 14-234 will apply to emergency small business loans just as with any other contract with the local government.  For more information, see Frayda Bluestein’s blogs here and here.  Even if an action taken by the board related to a small business emergency loan program doesn’t rise to a violation of G.S. 14-234, board members still must be mindful of conflicts that affect their own financial interests, which Frayda Bluestein discusses in a blog post here.

Finally, all public officials and employees must avoid using nonpublic information in any manner that results in a financial benefit to themselves or others to avoid violating G.S. 14-234.1, which is also punishable as a Class 1 misdemeanor.  Local officials and employees might receive requests from small businesses for help with obtaining a loan.  Assisting them with the loan process does not, in and of itself, violate G.S. 14-234.1, but care must be exercised to avoid violating the law. Officials should consult with the local government’s attorney if they believe they have a conflict of interest.

Need help?

The Development Finance Initiative (UNC DFI) assists local governments and their nonprofit partners by providing development and finance expertise when they need it most. UNC DFI, as a program of the School of Government, works on the government side of the table to set up development finance mechanisms such as revolving loan funds, whether the local government is relying on its own staff or contracting with a third party financial institution. More information is available here.

UPDATE on related resources for emergency loans for small businesses:

Blog posts:

Using Federal Coronavirus Relief Funds for Small Business Support

Local Government as Lender: Emergency Loans for Small Businesses

Local Government Emergency Loans for Small Businesses: Contracting with Financial Institutions for Loan Administration

Zoom Call:

Local Government Emergency Loans for Small Businesses

Advising support:

Advising support on local governments and emergency loan funds for small businesses, Development Finance Initiative (DFI)

One Response to “Local Government Emergency Loans for Small Businesses: Contracting with Financial Institutions for Loan Administration”

  1. The Development Finance Initiative (DFI), a program of the School of Government, is available to assist local governments who are considering or in the process of creating their own small business emergency loan programs to provide bridge loans to local businesses impacted by COVID-19.

    The DFI team is available to provide one-hour phone consultations at no charge with local government staff to think through loan program structures and financial modeling on a first-come, first serve basis. Additional advising is also available upon request. To schedule a call, please fill out the webform located here: https://www.sog.unc.edu/webforms/dfi-covid-advising

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