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Chapter 11 Debtors Clash With the SBA Over PPP Eligibility

Client Alert

Authors: Deborah Kovsky-Apap and Richard E. Hagerty

5/01/2020
Chapter 11 Debtors Clash With the SBA Over PPP Eligibility

The SBA’s Rules Exclude Bankruptcy Debtors From Relief Under the Paycheck Protection Program

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which was signed into law on March 27, funnels aid to small businesses through the Paycheck Protection Program (PPP). The PPP expands the Small Business Administration’s (SBA’s) Section 7(a) loan program to provide federally backed loans of up to $10 million to small businesses. The loans will be forgiven if they are used for approved purposes — primarily payroll and other day-to-day operating expenses — and if the small business borrower meets other requirements. More details on the PPP are available in our summary of the program and on our COVID-19 Resource Center.

The government initially allocated $350 billion to the PPP, which was depleted by April 16. The PPP was replenished with another $310 billion on April 24, with loan processing resuming on April 27.

Nothing in the CARES Act, the Bankruptcy Code or any regulation prevents a debtor in bankruptcy from borrowing funds under the PPP. Nevertheless, on March 31, the SBA released interim final rules that disqualified prospective borrowers if the business or any of its owners was “presently involved in a bankruptcy.”

On April 28, the SBA released a new set of interim final orders, clarifying that “[i]f 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.” Furthermore, if either the applicant or its owner 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. According to the SBA, 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.”

Debtors Seek to Use PPP Funds as Debtor-in-Possession Financing

Distressed small businesses that hope to reorganize under Chapter 11 of the Bankruptcy Code (or the new Small Business Reorganization Act) need to find some way of financing themselves through those bankruptcies. Many small businesses lack unencumbered assets to offer as collateral for secured debtor-in-possession (DIP) financing. The PPP is their only realistic chance at obtaining unsecured financing to make payroll, pay rent and successfully reorganize.

Since the launch of the PPP, numerous Chapter 11 debtors have sought to use PPP funds as DIP financing. Some of the debtors filed for bankruptcy after the loans were approved by the lenders, but before they were funded. At least one debtor filed an emergency motion to dismiss its own bankruptcy case (which the court granted) solely for the purpose of obtaining a PPP loan. Another debtor apparently waited until its PPP loan was funded, then promptly filed its bankruptcy with the cash in hand to finance its case.

Lawsuits Proliferate as Debtors Challenge the SBA’s Efforts to Shut Them Out

To date, at least a dozen lawsuits have been filed by debtors across the country seeking access to PPP loans to enable them to restructure in bankruptcy, with more certain to follow (at least until the program once again runs out of money).

One of the debtors challenging the SBA recently won a significant victory in bankruptcy court. The debtor, Hidalgo County EMS, the largest ambulance service in south Texas, had applied for a PPP loan from PlainsCapital Bank. The bank, consistent with the SBA’s guidance, asked on the application form whether Hidalgo was presently involved in a bankruptcy. Because Hidalgo answered “yes,” its application was denied. Hidalgo sued the SBA, seeking injunctive relief to prohibit the SBA from barring Hidalgo from access to the PPP simply because the company was in Chapter 11.

On April 24, in a scathing takedown from the bench, Chief Judge David R. Jones of the Bankruptcy Court for the Southern District of Texas eviscerated the arguments raised by the SBA to justify the exclusion of bankruptcy debtors from the PPP:

I see no authority anywhere for including those words in that form. It serves no purpose. I do find that by including the words "or presently involved in any bankruptcy," they are intended to be discriminatory. They are intended to be discriminatory toward debtors for reasons offered that somehow we lose control of the money, again I find to be completely frivolous. I cannot imagine anything less controlling than to simply give out money with no underwriting, with no oversight, and then complain that if I have a Federal judge who makes sure that the debtor complies with the law, ensures that the debtors file monthly operating reports, ensure that copies of bank statements are filed on the docket every month, that they somehow lost control. I simply don't buy it. I find the arguments to lack any good faith. . . .

[T]his can't be what Congress intended. This can't be the way that we are supposed to treat our fellow man in this time. It's inconceivable to me that this distinction could be drawn. The people that need the most help and who have sought protection under our laws are the people who are the targets of discrimination in a government support program; can't possibly be.

Judge Jones then granted the TRO, enjoining the administrator of the SBA and anyone acting in concert with her (including the bank) from considering Hidalgo’s bankruptcy in deciding whether to lend it money under the PPP. The TRO will continue until May 8, when a hearing will be held to determine whether it should be converted into a preliminary injunction.

The TRO entered in Hidalgo’s bankruptcy case only applies to Hidalgo’s loan application; it has no broader, nationwide effect. However, other debtors have already taken notice and at least one — Cosi Inc. — cited Judge Jones’s decision in its own complaint for injunctive relief against the SBA filed on April 28. Unlike Hidalgo, however, Cosi’s motion did not fare as well. On April 30, Judge Brendan L. Shannon of the U.S. Bankruptcy Court for the District of Delaware denied Cosi’s motion. While noting that he disagreed with the SBA’s decision and was dismayed at the harm it would cause, Judge Shannon concluded that he lacked the authority to enter a temporary restraining order.

The Takeaway: Don’t Give Up on the PPP

Despite the negative decision by Judge Shannon, as the lawsuits against the SBA continue to proliferate and gain steam, chances increase that more bankruptcy courts will grant the same relief as did the Southern District of Texas, or that the SBA will reconsider its interim final rule. If the PPP is still funded and your company would otherwise qualify for a loan, you should apply immediately even if your company is (or is about to be) in bankruptcy.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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