The Small Business Administration on April 24 issued an update to an interim final rule, crystalizing its view that applicants that have sought protection under the US Bankruptcy Code are not qualified borrowers under the Paycheck Protection Program. Almost simultaneously, a US bankruptcy court temporarily enjoined the SBA’s authority to enforce that determination, and a US district court has been asked to make similar findings in a separate case. The SBA’s discretion to deny PPP loans solely on the basis of a borrower’s bankruptcy remains a question, and the ability of operating debtors to use PPP proceeds to finance operations during bankruptcy hangs in the balance.
THE CARES ACT AND DEBTOR ELIGIBILITY UNDER THE PPP
US President Donald Trump on March 27 signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide relief to individuals and businesses suffering economic harm due to the coronavirus (COVID-19) pandemic.
The Paycheck Protection Program (PPP)—one of two business loan programs created under the CARES Act—initially allocated $349 billion to lending institutions to provide qualifying businesses with cash to cover payroll and other specified business expenses. PPP loans are guaranteed by the federal government, and funds expended in the eight weeks following loan disbursement are forgivable if used solely for payroll and other permitted business-related expenses. The initial PPP allocation was quickly exhausted, and Congress last week approved an additional $310 billion infusion.
As enacted, the PPP—unlike other programs under the CARES Act—contains no express limitation on the granting of loans to debtors in bankruptcy. The CARES Act grants the Small Business Administration (SBA) broad rulemaking authority, and the SBA formulated the PPP borrower and lender applications and accompanying instructions. Since the CARES Act became effective, the SBA has from time to time published clarifying guidance relating to both the scope of the PPP and the application process.
Prior to April 24, no supplemental interim guidance from the SBA expressly clarified that bankrupt borrowers need not apply. The PPP’s Borrower Application Form, however, requires applicants to disclose whether they are “presently involved in any bankruptcy” and notes that if the answer is yes, “the loan will not be approved.” The Lender Application Form similarly asks lenders whether the applicant has certified that “neither the Applicant nor any owner . . . [is] presently involved in any bankruptcy,” noting that the loan “cannot be approved” if the answer is no. As such, based solely on the applications, an applicant’s bankruptcy is a disqualifying fact.
Under an update to the Interim Final Rule[1] issued on April 24, the SBA confirmed that debtors are not eligible PPP borrowers, stating that bankruptcy would present an “unacceptably high risk of an unauthorized use of funds or non-repayment of unforgiven loans.” In reaching its conclusion, the SBA relied on the Bankruptcy Code’s policy against compelling an entity to make a loan or financial accommodation in bankruptcy. The Interim Final Rule also requires applicants that seek bankruptcy protection while their applications are pending to notify their lenders and withdraw their applications. This would avoid potential circumvention of the rule by applicants that wait until after an application is submitted to file for bankruptcy.
The Interim Final Rule also clarifies that hedge funds and private equity firms are not eligible PPP borrowers and, in light of the SBA’s issuance of updated PPP Loans Frequently Asked Questions (FAQs) on April 23 (also discussed in our prior LawFlash), created a grace period ending May 7 for the return of PPP funds by large companies with adequate sources of liquidity that reassessed their previously certified need for PPP funding. The Interim Final Rule does not provide a similar deadline for the return of loans by debtors that received PPP funding prior to the SBA’s clarifying guidance.
LOOKING TO THE COURTS FOR RELIEF
One bankruptcy court has taken the opposite view—at least on a preliminary basis—and other courts are being asked to make the same determination, including the US Bankruptcy Court for the District of Delaware and the US District Court for the Western District of New York.
On April 24, perhaps as the SBA was finalizing its updated guidance, the Bankruptcy Court for the Southern District of Texas found that the Bankruptcy Code likely prevents the SBA from discriminating against potential borrowers strictly on the basis of a pending bankruptcy and that the denial of loans on this basis probably exceeds the SBA’s rulemaking authority. The court granted temporary relief pending further proceedings. The bankruptcy court’s interim order is limited only to the specific debtor challenging the denial, and not to bankrupt PPP applicants generally. It may provide a footprint, however, for other debtors seeking similar relief.
The Hidalgo County EMS Complaint
The Hidalgo County Emergency Service Foundation (Hidalgo County EMS) is a medical transportation provider for a large portion of southern Texas, providing air and ground and 911 emergency responder services. Hidalgo County EMS sought bankruptcy protection in October 2019 and has continued to operate in chapter 11, including during the COVID-19 crisis.
Hidalgo County EMS, which earns revenue through the transport of patients, has used cash collateral pledged to the Internal Revenue Service to fund operations during its bankruptcy. Although calls for ambulance services in the region have diminished during the COVID-19 crisis, Hidalgo County EMS has maintained full staffing throughout its bankruptcy.
On April 3, when the PPP opened, Hidalgo County EMS applied for a loan of approximately $2.6 million from its bank, Plains Capital Bank, indicating on the borrower application that it is in bankruptcy. Hidalgo County EMS asserted that the loan would be used for working capital purposes permitted under the PPP. On April 9, the bank denied the loan on the basis that Hidalgo County EMS’s bankruptcy rendered it ineligible under the PPP.
The Bankruptcy Code prohibits a governmental unit from discriminating against debtors solely on the basis that they have sought bankruptcy protection. Among other things, section 525(a) of the Code states that a governmental unit
may not deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise, or other similar grant to, condition such a grant to, discriminate with respect to such a grant against . . . a person that is or has been a debtor under this title . . . solely because such bankrupt or debtor is or has been a debtor under this title . . .
On April 22, following the announcement of additional PPP funding, Hidalgo County EMS filed a complaint alleging that the SBA had violated its own authority, as well as section 525 of the Bankruptcy Code, in denying Hidalgo County EMS’s PPP application solely on the basis of its bankruptcy. Hidalgo County EMS asked the Bankruptcy Court for broad declaratory and injunctive relief, including to determine that the SBA had exceeded its authority by including the disqualifying bankruptcy question in the borrower application, as none of the PPP, Section 7(a) of the Small Business Act, or (at the time) the SBA’s own guidance had so contemplated.
The SBA’s responsive brief asserted that the SBA violated neither section 525 of the Bankruptcy Code nor its own authority. The SBA argued that section 525(a) has been narrowly construed by courts and does not apply to lending or loan guarantees; rather, section 525(c) applies and only in the context of student loans and grants, not the PPP. Second, the SBA argued that the bankruptcy exclusion was within its broad grant of authority—authority that was expanded under the CARES Act—and that, while nothing in the CARES Act expressly excludes debtors in active bankruptcy cases, nothing in the Act prohibits such an exclusion, either.
At a hearing on April 24, the Bankruptcy Court found Hidalgo County EMS’s argument compelling enough to grant a temporary restraining order, finding that Hidalgo County EMS had shown a substantial likelihood of success on both its claims. The Bankruptcy Court, however, was not willing to extend relief beyond the debtor before it. On April 25, the Court entered a temporary restraining order authorizing Hidalgo County EMS, in reapplying for a loan under the PPP, to strike the portion of the PPP application relating to Hidalgo County EMS’s bankruptcy status, and ordering the SBA to implement all aspects of the PPP without regard to Hidalgo County EMS’s bankruptcy proceeding. The Bankruptcy Court did not conclude that Hidalgo County EMS is otherwise qualified to receive a PPP loan or find that the SBA could not decline an application on other grounds.
A hearing on a preliminary injunction is scheduled for May 8, one day after the expiration of the SBA’s grace period to return funds for those companies reassessing their certification of necessity based on the April 23 SBA PPP Loans Frequently Asked Questions (FAQs).
Diocese of Rochester v. US Small Business Administration
The Dioceses of Rochester and Buffalo, New York are currently debtors in separate bankruptcy cases, each pending before the Bankruptcy Court for the Western District of New York. Each relies on revenue from monthly parish assessments, which derive from offertory collections during masses, including during Holy Week and on Easter Sunday.
In light of the current crisis, each diocese has forgone significant collections, worsening their financial condition. Having been informed that their status as debtors in bankruptcy disqualified them as borrowers, the dioceses together filed a complaint with the District Court for the Western District of New York containing allegations similar to those asserted by Hidalgo County EMS, which they amended on April 27 following the entry of the temporary restraining order in that case. A hearing on the request for a preliminary injunction is scheduled for May 15, 2020.
EFFECT OF THE CHALLENGES ON PENDING LOANS
Round Two of PPP Funding
The uncertainty generated by the temporary restraining order and the SBA’s latest guidance leaves both the SBA and potential operating borrowers in current reorganization proceedings in limbo, as the application process for the second round of PPP funding opened on Monday morning, April 27.
Likely, the SBA will take the position that its Interim Final Rule, issued within its authority, clarifies any remaining question and moots future challenges. The pending litigation, however, begs the very issue of that authority. Developments in both the Southern District of Texas and the Western District of New York may lead to a split and, in any event, the litigation likely will lead to expedited appellate proceedings.
The practical upshot of this places reorganizing debtor applicants at a disadvantage. With cash flowing on a first-come, first-served basis, the risk is that otherwise qualified debtors will miss the window of opportunity. This seems incompatible with other PPP policy directives geared to assist small and weakened businesses—in fact requiring as a central component of the application process those businesses to certify that the loan is “necessary to support the [applicant’s] ongoing operations.”
What About Companies that File for Bankruptcy After a PPP Application Is Filed?
In at least two current bankruptcies, the debtor’s future operations and reorganization may turn on the receipt and application of PPP loans:
- In Elemental Processing LLC, a chapter 11case involving a cannabidiol processor, the debtor filed for bankruptcy after filing its PPP application. That debtor has received loan proceeds and is holding the funds in escrow pending further instruction from the SBA. The PPP loan proceeds are intended to form a portion of its debtor-in-possession financing.
- In the Longview Power case, a prepackaged bankruptcy, the debtor received approval, but not the proceeds, of its PPP loan prior to filing for bankruptcy protection. If received, the Longview debtor expects to use the PPP proceeds to fund payroll.
Notwithstanding the potential applicability of section 525, the policy underlying the Bankruptcy Code frowns upon forced lending. With the SBA clearly signaling that it does not wish to be a provider of debtor-in-possession or exit financing, courts will need to carefully balance interests, as well as the policy underlying different sections of the Bankruptcy Code. In the meantime, the duration of COVID-19 business interruptions remains unclear, putting further pressure on small business owners.
The Bankruptcy Courts as Arbiters of CARES Act-Related Disputes
The SBA’s asserted debtor exclusion is only one disputed inconsistency between the CARES Act legislation and the SBA’s subsequent guidance. The bankruptcy courts may prove to be one of the initial arbiters of those disputes, although procedural and jurisdictional issues could create a time-consuming web of challenges—which may be one reason why the Diocese of Rochester plaintiffs filed their complaint in district court rather than bankruptcy court. The SBA’s initial brief in Hidalgo County EMS, for example ,asserted sovereign immunity, while the plaintiffs in Diocese of Rochester assert violations by the SBA of the federal Administrative Procedure Act.
These arguments, coupled with the bankruptcy court’s limited constitutional authority, raise interesting questions that may also play out as parties look to the courts for statutory clarification. If PPP funding is exhausted in the meantime, applicants could well be asserting damages claims instead of seeking loans.
CORONAVIRUS COVID-19 TASK FORCE
For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Force to help guide you through the broad scope of legal issues brought on by this public health challenge. We also have launched a resource page to help keep you on top of developments as they unfold.
[1] (Docket Number SBA-2020-0021)
