COVID-19 Response: Is a Bankrupt Small Business Eligible for a Small Business Loan Under the Paycheck Protection Program?
(May 6, 2020) - On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) to provide immediate assistance to individuals, families, and businesses adversely affected by the COVID-19 pandemic.
Relevant here, the CARES Act established the Paycheck Protection Program (PPP). Under the PPP, the U.S. Small Business Administration (SBA) can temporarily authorize and guarantee small business loans designed to incentivize small businesses to keep their workers on the payroll and help small businesses survive the pandemic. For additional details on this program, find previous alerts on our COVID-19 Government Regulations Practice page.
The SBA explains: “The loan will be fully forgiven if the funds are used for payroll costs, interest on mortgages, rent, and utilities (due to likely high subscription, at least 75% of the forgiven amount must have been used for payroll). Loan payments will also be deferred for six months. No collateral or personal guarantees are required. Neither the government nor lenders will charge small businesses any fees. Forgiveness is based on the employer maintaining or quickly rehiring employees and maintaining salary levels. Forgiveness will be reduced if full-time headcount declines, or if salaries and wages decrease. This loan has a maturity of 2 years and an interest rate of 1%.” See Paycheck Protection Program, SBA website.
Of note, in just round one of the PPP (through April 16, 2020), the SBA guaranteed 1,661,367 loans running out of program funds after less than two weeks. “After days of tense negotiations, congressional leaders agreed on new legislation to set aside another $310 billion for the PPP, with $60 billion of that money reserved for community lenders and smaller businesses without existing banking relationships” in round two, starting on April 27, 2020. See “Round Two Of The Paycheck Protection Program Is ‘More Frustrating’ Than First Time,” April 27, 2020, Forbes. Through May 1, 2020, the SBA reported that 2,211,791 loans have been made, totaling $175,473,247,908, with overall average loans of $79,000. See Summary for Second Round (as of May 1, 2020), SBA website. Round two funds are also expected to quickly run out if not already.
However, although PPP loans are meant to and do provide immediate assistance to small businesses adversely affected by COVID-19, the SBA has barred small businesses in bankruptcy, or that file for bankruptcy after applying for a PPP loan but before the loan is disbursed, from qualifying for the loan.
The SBA PPP Borrower Application Form and Fourth Interim Final Rule
Specifically, under question number one of the SBA PPP Borrower Application form, the applicant is asked whether the applicant is “presently” involved in any bankruptcy. If so, the application expressly states that “the loan will not be approved.”
Additionally, although the interim final rules published by the SBA on April 15 and 20, 2020 did not mention bankrupt debtors, the SBA published its fourth interim final rule on April 28, 2020 titled “Business Loan Program Temporary Changes; Paycheck Protection Program-Requirements-Promissory Notes, Authorizations, Affiliation, and Eligibility” [Docket Number SBA-2020-0021] (Fourth Interim Final Rule), making clear that a bankrupt small business, or a small business that files for bankruptcy after applying for a PPP loan but before the loan is disbursed, does not qualify for the loan:
“4. Eligibility of Businesses Presently Involved in Bankruptcy Proceedings
Will I be approved for a PPP loan if my business is in bankruptcy?
No. If the applicant or the owner of the applicant is the debtor in a bankruptcy proceeding, either at the time it submits the application or at any time before the loan is disbursed, the applicant is ineligible to receive a PPP loan. If the applicant or the owner of the applicant becomes the debtor in a bankruptcy proceeding after submitting a PPP application but before the loan is disbursed, it is the applicant's obligation to notify the lender and request cancellation of the application. Failure by the applicant to do so will be regarded as a use of PPP funds for unauthorized purposes.
The Administrator, in consultation with the Secretary, determined that providing PPP loans to debtors in bankruptcy would present an unacceptably high risk of an unauthorized use of funds or non-repayment of unforgiven loans. In addition, the Bankruptcy Code does not require any person to make a loan or a financial accommodation to a debtor in bankruptcy. The Borrower Application Form for PPP loans (SBA Form 2483), which reflects this restriction in the form of a borrower certification, is a loan program requirement. Lenders may rely on an applicant's representation concerning the applicant's or an owner of the applicant's involvement in a bankruptcy proceeding.”
The effective date of the Fourth Interim Final Rule is April 28, 2020. The Fourth Interim Final Rule further notes that “[t]his interim final rule applies to applications submitted under the Paycheck Protection Program through June 30, 2020, or until funds made available for this purpose are exhausted.”
Current Challenges to the Validity of SBA’s Ban on Bankrupt Small Businesses’ Eligibility for PPP Loans in Bankruptcy Courts
Small businesses presently in Chapter 11 reorganization have begun challenging the validity of the SBA’s ban on their ability to qualify for PPP loans in bankruptcy courts on two main grounds. One, the SBA exceeds its authority under the CARES Act, as the CARES Act does not deny bankrupt small businesses PPP loans. Two, the SBA’s bankruptcy-related exclusion violates section 525(a) of the Bankruptcy Code, 11 U.S.C., by unlawfully discriminating against an applicant solely on the basis that said applicant is a debtor under Title 11. See 11 U.S.C. § 525(a) (providing in relevant part that “a governmental unit may not deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise, or other similar grant to . . . a person that is or has been a debtor under this title . . . solely because such . . . debtor is or has been a debtor under this title).
For example, in Cosi Inc. v. Small Business Administration et al., Cosi Inc. (Cosi), a Chapter 11 debtor-in-possession, commenced an adversary proceeding before the United States Bankruptcy Court for the District of Delaware against the SBA for a temporary restraining order to bar the SBA from disqualifying it from applying for a loan through the PPP. Cosi did not get past the temporary restraining order stage. As Law360 described in its article “Bankrupt Cosi Loses Bid to Seek Small-Businesses Virus Funds,” from April 30, 2020, U.S. Bankruptcy Judge Brendan L. Shannon denied Cosi's bid for a temporary restraining order to bar the SBA from disqualifying Cosi from applying for a loan through the PPP. Judge Shannon said that although he disagreed with the SBA's decision to preclude bankruptcy debtors from receiving PPP money and was dismayed at the consequences and harm that will be caused to Cosi by denying its bid for relief from the court, he would defer to the recent directive under the Fourth Interim Final Rule from the SBA as to how loan funds are to be disbursed. Law360 further noted: “Judge Shannon pondered if Cosi would consider an emergency move to dismiss its Chapter 11 so it can seek the PPP funds, telling the company to keep the court apprised if it does want to change course given its current financial plight.”
In Hidalgo County Emergency Services Foundation v. Jovita Carranza, in her capacity as Administrator for the U.S. Small Business Administration, Hidalgo County Emergency Services Foundation (Hidalgo), another Chapter 11 debtor-in-possession, commenced an adversary proceeding on April 22, 2020 before the United States Bankruptcy Court for the Southern District of Texas against the SBA, seeking a temporary and preliminary injunction against the SBA’s bankruptcy-related exclusion under the PPP. Hidalgo argues that the SBA has exceeded its statutory authority to administer the PPP, because neither the CARES Act nor the Small Business Act bar PPP loans to bankrupt small businesses. Hidalgo further argues that SBA’s insertion of the bankruptcy-related exclusion violates § 525(a). On April 24, 2020, the Honorable David Jones in Houston granted Hidalgo’s request for a temporary restraining order against the SBA, scheduling the preliminary injunction hearing for this Friday, May 8, 2020. See “Judge Jones Grants Chapter 11 Debtor’s Request for TRO Against SBA Regarding PPP Loan Denial; Treasury Issues Interim Final Rule Indicating Debtor Loan Applicants Are Ineligible,” April 24, 2020, Reorg website.
Other adversary proceedings have been commenced against the SBA, resulting in favorable rulings for the small businesses. As noted in the Rochelle’s Daily Wire post on the American Bankruptcy Institute’s website, “Two More Judges Rule that Chapter 11 Debtors Are Eligible for PPP Loans,” from May 5, 2020: “According to Bankruptcy Judge Michael A. Fagone of Bangor, Maine, the ‘significant’ decline in income from the loss of revenue from elective and nonessential visitors meant the [debtor] hospital might be forced to close by early June. Judge Fagone held a hearing on April 30 and entered a TRO on May 1. Like Judge Jones, he barred the SBA from denying an application because the application is a chapter 11 debtor. . . . [He found that the SBA had no claim of sovereign immunity to preclude him from entering a carefully tailored temporary restraining order and the debtor had shown a likelihood of success on the merits on its Section 525(a) claim, noting] [w]hile Section 525(a) does not apply to loans, he said that the ‘CARES Act is a grant of aid necessitated by a public health crisis.’” He further required “the SBA to hold bank funds to make a ‘loan’ if the debtor is later found eligible.” The temporary restraining order is to remain in effect through May 14, 2020 and a status conference on the preliminary injunction motion was scheduled for May 5, 2020.
The American Bankruptcy Institute post also noted an interesting case out of New Mexico, in which U.S. Bankruptcy Judge David T. Thuma held a hearing on April 30 to consider a motion for a preliminary injunction filed by the Roman Catholic Church of the Archdiocese of Santa Fe, New Mexico. “He went further than granting a preliminary injunction: He entered a ‘final judgment’ in favor of the debtor in the adversary proceeding brought by the archdiocese . . . [finding] that the archdiocese ‘clearly met’ all of [the requirements] . . . Taking a new tack regarding the PPP, Judge Thuma held that the SBA’s denial of the loan application was ‘arbitrary and capricious,’ in violation of 5 U.S.C. §706(2)(A).” The American Bankruptcy Institute further notes: “Judge Thuma said ‘it was arbitrary and capricious for [the SBA] to engraft a creditworthiness test where none belonged.’ He went on to find that the Cares Act ‘clearly addresses’ eligibility requirements and ruled that the SBA had no authority ‘to change eligibility requirements.’ . . . Judge Thuma also found a violation of Section 525(a) because ‘the PPP is not a loan program. It is a grant or support program.’ He added teeth to his judgment by declaring that the archdiocese could seek compensatory and, ‘if appropriate,’ punitive damages if the SBA’s actions result in the debtors not receiving the $900,000 it requested.”
The SBA has made it clear that bankrupt small businesses, or small businesses that file for bankruptcy at any time before the PPP loan is disbursed, are ineligible to receive a PPP loan. Although the SBA’s exclusion may incentivize some bankrupt small businesses to dismiss their Chapter 11 cases to potentially receive PPP funding, others are challenging the validity of the exclusion in the bankruptcy courts. As noted by the American Bankruptcy Institute in its article "This DIP Loan Should be Brought to You By Someone Who CARES (or "You Can’t Get There From Here"): A Plea for Rationality: Part Two": “[r]esolution of this issue is critical for the borrowers that need these funds and need them immediately.”
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Richard S. Lauter, Partner
Maria L. Garcia, Associate