The CARES Act and Venture-Backed Companies: What We Know Now

It’s no secret that the CARES Act rollout was a mess, particularly for VC-backed startups. Over a period of a month and half, venture capital firms and their portfolio companies faced an ever-changing regulatory landscape, grasping for an understanding of whether VC-backed startups would be eligible for CARES Act loan programs – in particular the PPP and EIDL programs.

While some level of clarity actually was provided, it was not before quite a number of companies prematurely returned their loans out of fear of ineligibility.

But we’re not out of the woods yet. For VC-backed startups who received EIDL or PPP loans, regulatory compliance is an ongoing issue that goes beyond initial eligibility. And ignoring the rules that exist around these programs can be costly.

The False Claims Act allows the government to seek both civil and criminal penalties against companies misusing government funds. On top of this, individual whistleblowers (with their hungry plaintiffs’ attorneys) also have standing to sue on behalf of the government.

Liability under the False Claims Act can go beyond the company misusing the funds but to individuals (including directors and officers), as well.


The two most popular CARES Act program for startups – EIDL and PPP – have specific requirements for how loan funding may be used. And those requirements are not the same.

PPP loans are limited to use for “payroll costs.” These are defined by statute and include traditional compensation components (e.g. salary, wages, commissions, tips), payments towards health care benefits, certain retirement benefit payments, vacation/sick/family leave, local and state payroll taxes, and severance payments.

But it’s easy to run afoul of these limitations. For example, a company cannot use funds for compensation of an employee in excess of $100,000. In addition, while state and local payroll taxes are a proper use of funds, federal withholding is not.

And with respect to the PPP loans, there is the question of what portions of the loan are forgivable. The SBA has been coming out with updated guidance to simplify the loan forgiveness process and calculations of forgivable expenses. But just as a company can get in trouble for misusing PPP funds, it can run into the same problem by obtaining forgiveness for funds that are not so entitled.

For EIDL funds, the uses are far broader than PPP loan funds. Of course, at the outset, one cannot claim to have used EIDL funds for the same expenses as were purportedly paid with PPP funds. But that aside, EIDL funds are only to be used for working capital during the economic emergency (in this case the COVID-19 pandemic).

What is important is to avoid any of the expressly disallowed EIDL expenses. 13 CFR § 123.303 sets out several categories of expenses for which EIDL funds cannot be used. These include:

  1. Refinancing prior debt
  2. Making payments on government loans
  3. Paying any government fine or penalty
  4. Repairing physical damage to property
  5. Paying money to company owners, shareholders, partners, or officers, except “reasonable remuneration directly related to the performance of services for the business.

So, for example, just because EIDL rates may be much better than a pre-existing business loan your company may have outstanding, you cannot use your EIDL funds to pay down that debt.


So, what can happen if you wind up using CARES Act funds in impermissible ways?

The False Claims Act (FCA), 31 U.S.C. §§ 3729 – 3733, provides for civil and criminal liability for “knowingly” submitting a false claim to the federal government. This can include misusing government funds.

False Claims Act liability only arises when funds were “knowingly” misused. It is not a strict liability statute nor does it seek to punish negligence. But that does not mean that it needs to be proven that the company (or individual defendants) intended to defraud the government.

What are the consequences of violating the False Claims Act?

While the FCA does authorize the government to pursue criminal penalties, more commonly the consequence of FCA liability is a civil action for monetary damages. But those monetary damages can be severe.

First, FCA imposes a mandatory penalty on each defendant per violation of between $11,000 and almost $24,000.

Second, liable defendants can be forced to pay three times any damages suffered by the government.

Third, if the government (or a whistleblower, as discussed below) is successful on an FCA claim, the defendants have to reimburse attorneys’ fees.

The thread of whistleblower lawsuits

Even if you think that the government is unlikely to take interest in pursuing your startup under the FCA, the law permits a whistleblower to pursue claims on their own. This is called a qui tam action.

Qui tam actions under the FCA can be a lucrative endeavor. Whistleblowers bringing qui tam actions can be awarded up to 30% of the recovery in the lawsuit.

And there is a sizable plaintiff’s attorney practice centered around bringing qui tam claims. Needless to say, there are many lawyers waiting to recruit whistleblowers to file False Claims Act lawsuits.

Who can be held liable?

Importantly, FCA liability goes beyond the startup company itself. Director, officers, and even stockholders can be held jointly and severally liable for FCA claims, if an individual takes affirmative steps to cause the company to violate the FCA.

Given startups are often cash poor, we can readily expect plaintiff attorneys to look for deep-pocketed investors against whom to file qui tam lawsuits under the FCA.


Avoiding False Claims Act liability

Obviously the best way to mitigate the risk of FCA liability is to avoid misusing CARES Act funds in the first place. This means understanding the, admittedly complex and ever-changing, regulations around the PPP and EIDL programs.

It also means documenting your use of government funds. Startups – particularly in the early stages – can be notoriously lax about documentation. But, at a minimum, you want to be able to show that at the time you used the funds you were acting reasonably and in good faith to comply with government regulations. Creating documentation later – after you are investigated or sued – will not be helpful.

The FCA does allow for an advice of counsel defense, if you relied on your attorneys’ advice in how you used government funds. You have to be able to show you made a full disclosure of the facts to your counsel and that you acted in good faith in reliance on counsel’s advice. Moreover, you will have to waive the attorney-client privilege as part of relying on the defense – perhaps very broadly.

What about indemnification or D&O insurance?

For individuals against whom an FCA suit is brought, one way risk can be mitigated is through indemnification or D&O insurance.

It is important, as a director or officer, that you have a contractual right to indemnification with your company. The FCA does not provide for indemnification nor contribution as between defendants. Nor do courts recognize a common law right to indemnification. Thus, the only possibility for a director or officer to be indemnified is by contract.

Another avenue for mitigating risk is D&O insurance. But you need to be careful about the details of your policy. In particular, you would be wise to review your policy in three areas:

  1. Does your policy have exclusions for claims arising from fraud, dishonesty, or improper profit? These types of claim exclusions, depending on the details, may result in an insurer denying coverage for FCA claims.
  2. What is the definition of a covered “loss” under your policy? Some policies have exclusions for government fines or penalties. Your insurer may, on this basis, deny coverage.
  3. Does your policy have an exclusion for claims made by an insured? If an insider whistleblower brings a qui tam lawsuit against you, your insurance company may deem that to be a claim brought by the company itself. Therefore, the insurance company may argue you aren’t entitled to coverage.

So, while insurance can be useful, it is important to truly understand your policy before you can have comfort it may be of use.

Don’t create whistleblowers

While the profit motive itself may be sufficient to incentivize people to bring qui tam lawsuits under the FCA, companies would be wise not to create disgruntled insiders who may seek out opportunities to harm the company this way.

For example, softness in the economy and capital markets have many startups worrying about down rounds that may wipe out the equity employees have built. This may be an unfortunate necessity. But look for ways to take care of company employees nonetheless. If their only ‘upside” in the company after a down round is through a lawsuit, the company may have unnecessarily motivated people to become whistleblowers.

At the same time, companies may want to consider being generous with severance when terminating employees. This may create some good will with employees who depart, even under less than ideal circumstances. It also allows the company to get a broad release of claims.

Unfortunately, most courts have held that an employee release does not bar the employee from later bringing a qui tam lawsuit under the FCA, unless the government was made aware of the underlying allegations of law before the release was executed – which itself is rare.

The typical tech startup has little occasion to deal with government programs. While particularly at the early stages, startups have a tendency to focus on their technology and business, to the exclusion of being careful about legal niceties. The strings attached to government funding do not allow this. Avoiding liability means taking government regulations seriously from the beginning. Thankfully, despite the initial rockiness of the CARES Act programs, there is more and more clarity as time has gone on. With the proper attention and the right advisors, CARES Act funding can serve as a lifeline, not a liability.

About the authors: Mital Makadia and David Siegel are partners at Grellas Shah LLP, where they counsel tech startups and investors in general corporate, venture financing, M&A, and other transactional matters. Ms. Makadia previously practiced securities law for public companies at two major east coast law firms. Mr. Siegel spent several years practicing complex litigation for a prominent AMLAW 100 firm and also guided various organizations through government funding audits during the Great Recession.