Debtors Challenge SBA Rule That Prohibits PPP Loans to Bankrupt Borrowers

Debtors are challenging these rules because there is nothing in the CARES Act, that makes businesses in chapter 11 ineligible for the emergency funding. In addition, several members of Congress have urged the SBA to waive the agency’s bankruptcy restriction to allow funding to critical-access hospitals and federally qualified health centers.

On April 24, 2020, the SBA issued Interim Final Rule Number 4, which states, in relevant part:

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 SBA argues that the bankruptcy exclusion is justified because the Small Business Act requires that all loans made or guaranteed by the SBA must be of “such sound value or so secured as reasonably to assure repayment.” The SBA explains that excluding borrowers in chapter 11 from PPP loans is justified because doing so allows expedited underwriting and because “loans to debtors in bankruptcy would present an unacceptably high risk of an unauthorized use of funds or non-repayment of unforgiven loans.”

On April 30, in In re Cosi, Inc., Delaware Bankruptcy Judge Brendan Linehan Shannon denied Cosi’s motion for a temporary restraining order against the SBA. If granted, the temporary restraining order would have prevented the SBA from denying Cosi a loan under the PPP. Judge Shannon stated that although he disagrees with the SBA’s decision to preclude bankruptcy debtors from receiving PPP money and is “dismayed at the consequences” that will be caused to Cosi, he would defer to the SBA as to how loan funds are to be disbursed.

Judge Shannon’s decision is in contrast to a recent decision in the Southern District of Texas. In In re Hidalgo County Emergency Service Foundation, the debtor filed an adversary action against the SBA alleging that the SBA restriction violated Section 525(a) of the Bankruptcy Code. Section 525(a) prohibits a governmental unit from denying “a license, permit, charter, franchise, or other similar grant” to a debtor in bankruptcy. In opposition, the SBA argued that Section 525 should be read narrowly and does not apply to loans or loan guarantees. Chief U.S. Bankruptcy Judge David R. Jones agreed with Hidalgo and granted the temporary restraining order. Under the order, Hidalgo is authorized to modify and submit its PPP application to exclude information regarding its bankruptcy. The SBA, and any lender acting in concert with the SBA, is directed to process Hidalgo’s application without any consideration of the involvement of Hidalgo or any owner of Hidalgo in any bankruptcy. The court will conduct a hearing on Hidalgo’s application for a preliminary injunction on May 8. Unlike Cosi, Hidalgo involves essential ambulance services.

Similarly, on April 21, 2020, the debtor in In re Roman Catholic Church of the Archdiocese of Santa Fe, filed an adversary action against the SBA alleging that, in addition to violating Section 525(a) of the Bankruptcy Code, the SBA rule exceeds the SBA’s statutory authority under the Cares Act pursuant to the Administrative Procedure Act, 5 USC § 701 et seq. (the “APA”). The APA provides that implementing rules cannot exceed the authority granted in a statute. According to the debtor, nothing in the Cares Act, authorizes the SBA to exclude debtors in bankruptcy from the PPP. The debtor seeks a declaratory judgment and injunctive relief enjoining the SBA from denying the debtor a loan under the PPP based on the debtor’s status as a bankruptcy debtor. The SBA contends that it was delegated broad authority to implement the PPP and the bankruptcy exclusion falls within this authority. A hearing on the debtor’s motion for a preliminary injunction against the SBA was scheduled for this morning.

It seems certain that the SBA policy excluding borrowers in bankruptcy form the PPP has discouraged PPP loan applications from bankruptcy debtors and is likely to have caused many applicants to withdraw their applications or be denied. For those applicants who have challenged the exclusion in court, it remains to be seen whether those challenges, even if successful, will be resolved in time to secure PPP loans from the current round of funding.

The SBA Focus Group of the COVID-19 Task Force at Klehr Harrison stands ready to assist you in your business and legal needs. We will continue to provide additional information and guidance as the PPP loan program is implemented.

Author Robert Johns is of counsel in the Bankruptcy & Restructuring Department at Klehr Harrison.