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Banks have PPP protection but still must identify clear fraud, lawyers say

More fraud cases from the Small Business Administration's Paycheck Protection Program will likely come to light, and banks will need to do their part to help identify applicants' false statements, according to attorneys.

The first such Justice Department claim — an instance of potential fraud discovered in Rhode Island — came relatively quickly, about a month after the program started April 3. According to an affidavit, an FBI investigation found probable cause that two suspects conspired to make false statements in their loan applications, making such claims as requests to pay employees of businesses that were not operating prior to the start of the COVID-19 pandemic in addition to other charges.

The application was submitted to Middletown, R.I.-based BankNewport, which did not issue the funds, according to the affidavit. BankNewport did not respond to requests for comment.

More such cases are expected as increased resources are put toward identifying potential fraud in PPP loan applications, attorneys said.

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Investigators will likely probe at least three types of fraud cases, said Damien Specht, a partner at Morrison & Foerster LLP. Some cases will look to uncover outright fraud, which is what the Justice Department is trying to find in the Rhode Island case. Others may involve entities believing they meet the small business requirements but do not, and finally, some small business loan applicants may not have necessarily needed the funds, said Specht. "The question becomes: Are you going to really second-guess people who did this in good faith?"

The Justice Department and SBA will likely use data to find potential fraud, said David Rybicki, a partner at K&L Gates LLP. They may use past business filings with the IRS or SBA to find anomalies, he said. Most will not be found using witnesses like the case in Rhode Island, he said. "SBA is sitting on an enormous amount of borrower data right now," he said. "A lot of cases will be generated through the data analytics approach."

The volume of loans and speed needed to administer the program have made the potential for fraud more likely. "Federal authorities are clearly going to be concerned that this is an environment that's ripe for potential financial fraud," said Reginald Harris, a partner at Bryan Cave Leighton Paisner LLP.

The Bank Secrecy Act puts some responsibility on banks to report suspected fraud to authorities, Harris said. But the coronavirus relief act that created the PPP made it so that banks would be "held harmless" for borrowers' failure to comply with program criteria. The CARES Act outlined that the lender was able to rely on data from borrowers, said Rybicki.

"Congress's objective was to pump as much money as possible into the economy as quickly as possible," said Sara Lord, a partner at Arnall Golden Gregory LLP in an interview. With traditional regulations in place, the wait time would have been much longer. "It's fair to say that the CARES Act goes out of its way to limit the bank's responsibility," said Lord.

Still, banks need to make sure they are doing some due diligence, Mark Schamel, a partner at Womble Bond Dickinson LLP said. "They will need to report (and not approve) clearly fraudulent applications, but with the press of time and overwhelming number of applications, there is just no way any bank on the planet is going to have the time and ability to do the due diligence necessary to guarantee the loans," Schamel wrote.

The way the law was written encourages small banks to participate in the program as well, said Rybicki. Compliance is often burdensome for small banks that do not have the resources of their larger counterparts. "A lot of smaller lenders are participating in part because of the fact that there aren't significant added compliance burdens," said Rybicki.

Community banks may be better positioned to spot potential fraud than larger banks, due to being more familiar and having more long-time relationships with customers, Lord said.

But small banks often find compliance more burdensome. "Smaller banks may have a tougher time just by virtue of the lack of the type of resources that bigger banks may have," said Harris.

Despite the potential for fraud, Rybicki said lenders and businesses will still be eager to participate in the program. "The statute and the interim final rule were very intentionally designed to incentivize lender participation," he said.