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. Subsequently, dozens of debtors have looked to the bankruptcy courts for relief from the SBA’s unilateral clarification. This LawFlash covers debtor eligibility under the PPP as well as recent legislation and key court decisions moving the needle in this space.
Almost simultaneously with the SBA’s release of its interim final rule stating its view that debtors are not qualified PPP borrowers, a Texas bankruptcy court temporarily enjoined the SBA’s authority to enforce that determination. The US Court of Appeals for the Fifth Circuit vacated that decision after determining that the SBA is protected by limited sovereign immunity. In the intervening period, numerous debtors have looked to the bankruptcy courts for relief, with most courts deciding the issues on the merits—including one district court—leading to a split over the SBA’s discretion to deny PPP loans solely on the basis of a borrower’s bankruptcy. Meanwhile, debtors obtaining their PPP loans prior to filing have seen few challenges to their requests to use PPP proceeds to fund operations during bankruptcy.
Subsequent PPP legislation, including the Paycheck Protection Program Flexibility Act of 2020 enacted on June 5, clarified several points and further extended the maturity and forgiveness period of the PPP, but did not address the ineligible debtor issue, which continues to be fought in the courts. The second round of funding of the PPP has not been exhausted and remains available for eligible borrowers, although the deadline to borrow will expire shortly.
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 subsequently 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 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 first decision on the scope of the SBA’s authority to exclude debtors from PPP eligibility was issued by the Bankruptcy Court for the Southern District of Texas on April 24, when Judge David Jones 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. That court subsequently issued a preliminary injunction that echoes the TRO, although the effectiveness of that injunction was stayed pending an expedited appeal—and was ultimately vacated on June 22, when the Fifth Circuit determined that the Small Business Act provided the SBA with limited sovereign immunity that stripped the courts of injunctive powers. In the period between the bankruptcy court’s initial order and the Fifth Circuit’s order vacating the preliminary injunction, several courts hearing the issue have split on the scope of the SBA’s authority, as well as the courts’ own authority to intervene—and to enjoin the SBA.
The Hidalgo County EMS Complaint
The bankruptcy of Hidalgo County Emergency Service Foundation (Hidalgo County EMS) led to the first decision in the PPP eligibility debate. 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. The SBA also asserted that the Small Business Act contained a narrow waiver of sovereign immunity that protected it from injunctive relief. While section 634(b)(1) of the Small Business Act generally permits suits against the SBA in courts with proper jurisdiction, “no attachment, injunction, garnishment, or other similar process” may issue.
At a hearing on April 24, the bankruptcy court found Hidalgo County EMS’s argument compelling enough to grant a temporary restraining order (TRO), 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.
On May 8, following a hearing, the bankruptcy court issued a preliminary injunction consistent with its April 25 temporary restraining order, rejecting the SBA’s sovereign immunity argument and finding that the PPP is not a loan program, but more like a “conditional grant” or support program. The SBA appealed, and on May 12, the district court stayed the effectiveness on the bankruptcy court’s order pending an expedited appeal, and the case was certified for direct appeal to the Fifth Circuit. On June 22, without oral argument, the Fifth Circuit issued a three-page opinion vacating the bankruptcy court’s preliminary injunction, noting that binding Circuit precedent “absolutely prohibited” any act by a court to enjoin the SBA. In so ruling, the Fifth Circuit declined to accept Hidalgo County EMS’s invitation to revisit or create an exception to that bright-line rule “under the extreme facts and highly compressed time frame presented” in the case.
Developments Following the Initial Hidalgo County EMS Decision
The Final Interim Rule was issued within hours of the bankruptcy court hearing on the Hidalgo County EMS TRO, and prior to the entry of the order in that case. Since the PPP’s implementation, courts in multiple districts have heard or been asked by debtors to enter TROs on similar bases. Initially, the decision was fairly evenly split: In addition to a second order from Judge Jones in the Southern District of Texas, bankruptcy courts in the Districts of Maine, New Mexico, Vermont, and the Eastern District of Kentucky granted TROs, finding the SBA’s determination to exclude debtors arbitrary and capricious, particularly in light of continuing court oversight of entities in bankruptcy. Bankruptcy courts in Delaware, the Western District of Texas, and the Northern District of Ohio took the opposite view. Since then, the tide seems to have turned. The Bankruptcy Court for the District of Maine, which initially granted a TRO to two hospitals, has recommended the denial of further relief following further proceedings in those cases, and has maintained a consistent stance in another case. Other recent cases similarly have yielded a wave of denials of relief to would-be borrower debtors on substantive grounds.
The courts in the foregoing cases declined to make an express finding that the applicant debtor was, but for its bankruptcy, otherwise qualified for a PPP loan. Only Judge David Thuma of the Bankruptcy Court for the District of New Mexico, went further, effectively ordering the SBA to grant the PPP loan application of the Roman Catholic Church of the Archdiocese of Santa Fe, and authorizing the Archdiocese to seek damages if the loan was not granted. The SBA filed a notice of appeal on May 15. No further proceedings have occurred before the district court.
While the PPP tally was initially fairly even, courts in May and June have far and away determined that the SBA was within its authority in promulgating the bankruptcy exception, and that it did not violate the Bankruptcy Code in doing so. A survey of a few of those cases follows:
The purpose of a PPP loan is to help small businesses pay their employees and maintain operations to allow them to restart quickly over the next few months. SBA decided that this purpose would not be served by including all bankruptcies. Certain creditors, including administrative creditors, could assert claims to the PPP loan funds that would interfere with its authorized uses and the requirements for PPP loan forgiveness. SBA, in consultation with the Department of the Treasury, determined there should be one streamlined rule that applies to all debtors in bankruptcy to avoid the need for case-by case-reviews.
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.
The SBA has taken the position that its Interim Final Rule, issued within its authority, clarifies any remaining question and moots future challenges, clearly signaling that it does not wish to be a provider of debtor-in-possession or exit financing. The split among the courts as to the applicability of Bankruptcy Code section 525 begs the very issue of that authority—although most courts have made short work of the issue. While the split led to expedited appellate proceedings in Hidalgo County, limitations on liquidity may make other appeals impracticable. In the meantime, while some areas have reopened, the duration of COVID-19 business interruptions and their long-term effect remains unclear, and has led to increased pressure on small business owners.
The practical upshot is that reorganizing debtor applicants have been left at a disadvantage—including to the extent they have spent estate resources fighting the PPP battle. With cash flowing on a first-come, first-served basis, and the PPP set to sunset shortly, otherwise qualified debtors may miss a 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 Seeking – or Receiving – a PPP Loan?
In addition to TRO proceedings, the lack of clarity in the SBA’s guidance is leading to other outcomes among debtors, including those PPP recipients who filed for bankruptcy first, and asked PPP questions later.
The Interim Final Rule requires applicants who file for bankruptcy protection while their applications are pending to notify their lenders and withdraw their applications. But the Interim Final Rule says nothing about debtors that receive funds immediately prior to filing. The failure to address that circumstance seems to leave no basis for disqualifying entities that receive funding on the threshold of bankruptcy. The silence may be intentional, as post-bankruptcy disqualification raises potential estate property, stay violation, and cash collateral issues.
It remains to be seen whether the SBA will respect this bright line, or seek to preclude loan forgiveness or enforcement by lenders of their guarantees, including on the basis that a borrower’s preparation for a potential filing is a disqualifying present involvement in a bankruptcy. In contrast, the Federal Reserve and the Treasury took a different approach with respect to the Main Street Lending Program where an applicant is required to certify as of the date of origination of a Main Street loan and after giving effect to such loan, that it has the ability to meet its financial obligations for at least the next 90 days and does not expect to file for bankruptcy during that time period. Read our LawFlash on the PPP for more.
The Plot Thickens Further: Cash Collateral and Unsecured Creditor Concerns
Timing and cash collateral issues—among others—initially appeared to be front and center in the TooJay’s bankruptcy. From a practical standpoint, although some of these issues may already be moot, they are illustrative for the lenders providing PPP funding, as well as the SBA, which guarantees them of issues that should be considered.
TooJay’s has two layers of pre-petition financing, which are secured by collateral that includes cash collateral. While TooJay’s takes the position that the PPP loan proceeds are not cash collateral, there is no evidence that these funds were segregated from TooJay’s general operating accounts.
The court’s interim orders allowing the use of cash collateral contains a broad definition of that term, including “all cash proceeds from use or conversion of real or personal property, all deposits, refund claims and rights; and the proceeds of any sale, transfer or other disposition” of prepetition collateral.
The Galileo Learning debtors may have anticipated similar issues, as their first-day papers indicated that their PPP loan proceeds are held in a segregated account, and that they will transfer the PPP funds to their operating account on an as-needed basis.
The creditors’ committee in the Areway Acquisition metal finishing case also recently focused on this point, moving to intervene in the PPP-related adversary proceeding in that case. The committee’s motion did not take a position with respect to the Areway debtors’ eligibility for a PPP loan, but noted that the debtors’ loyalties were owed to all of their creditor constituencies, creating a possible conflict. Because Areway’s failure to comply with PPP guidelines could result in the loss of forgiveness of the loan, harming recoveries to the general unsecured pool, the committee sought to be “the voice of the unsecured creditors during the negotiation and crafting of any order” resulting from the proceeding. Ultimately the court granted the committee’s motion, but denied Areway’s request for a TRO ruling instead in favor of the SBA.
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, and a restriction governed by whether a recipient receives loan proceeds immediately before bankruptcy or during bankruptcy seems arbitrary, particularly since the likelihood of misuse diminishes in the face of the significant US Trustee and court oversight present in most Chapter 11 cases.
While the bankruptcy courts are generally proving to be the initial arbiters of those disputes, procedural and jurisdictional issues are contributing to a time-consuming web of challenges. The SBA has asserted sovereign immunity—an assertion that proved successful before the Fifth Circuit—and invoked the Anti-Injunction Act, while various plaintiffs assert violations by the SBA of the federal Administrative Procedure Act (APA) and seek writs of mandamus.
At least four other courts have recognized a jurisdictional issue unrelated to sovereign immunity:
As evidenced by Hidalgo County EMS, the non-Bankruptcy Code-based arguments, coupled with the bankruptcy court’s limited constitutional authority, have raised interesting questions that are now playing out as parties look to the courts for statutory clarification. If PPP funding is exhausted or the program expires before these issues are finally decided—which at this point seems a forgone conclusion—applicants could well be asserting damages claims instead of seeking loans. Absent a writ of certiorari and a Supreme Court reversal in Hidalgo County EMS, that relief likely will not be available in the Fifth Circuit.
Given an unpredictable future and the possibility that an intervening bankruptcy could render previously solicited PPP funds unauthorized, borrowers should only make the required certifications in the PPP application when they can do so comfortably and in good faith. Accordingly, business owners should closely monitor their financials, including good faith projections of future performance, and speak with advisors before applying for and disbursing proceeds of a PPP loan, particularly if the business is evaluating the potential need for bankruptcy relief down the road.
Morgan Lewis’s finance and restructuring lawyers have a command of the rapidly evolving issues companies are facing during these challenging times, and we stand ready to help our clients address and overcome these and other COVID-19-related concerns.
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Sheila A. Armstrong
 (Docket Number SBA-2020-0021)
 iThrive Health, LLC v. Carranza (In re iThrive Health, LLC), Adv. Proc. No. 20-00151 (Bankr. D. Md. June 8, 2020) (TRO denied upon determination that Fourth Circuit precedent prevented the issuance of injunctive relief); Henry Anesthesia Assoc. LLC v. Carranza (In re Henry Anesthesia Assoc. LLC), Adv. No. 20- 6084 (Bankr. N.D. Ga. June 4, 2020) (TRO denial followed by dismissal); Hartshorne Mining, LLC. v. Carranza (In re Hartshorne Hold., LLC), Adv. No. 20-4012 (Bankr. W.D. Ky. June 1, 2020) (further injunctive relief denied following initial grant of TRO based on failure to show substantial likelihood of harm; emergency motion to reconsider denied); Schuessler et al. v. SBA (In re Schuessler et al.), Adv. No. 20-2065 (Bankr. E.D. Wis. May 21, 2020) (consolidated with Steffen et al. v. SBA (In re Steffen et al.), Adv. No. 20-2068 (Bankr. E.D. Wis. May 21, 2020) and Thull Farms, LLC v. SBA (In re Thull Farms, LLC), Adv. No. 20-2069 (Bankr. E.D. Wis. May 21, 2020)) (declaratory and injunctive relief denied with respect to section 525(a) of the Bankruptcy Code; non-core matters before District Court to rule upon recommendations); Starplex Corp. v. Carranza, Adv. No. 20-00095 (Bankr. D. Ariz. May 21, 2020) (recommending denial of relief through proposed findings of fact and conclusions of law); NAI Cap., Inc. v. Carranza (In re NAI Cap., Inc.), Adv. No. 20-01051 (Bankr. C.D. Cal. May 20, 2020) (TRO denied); PPV, Inc. v. Carranza (In re PPV, Inc.), Adv. No. 20-03054 (Bankr. D. Or. May 20, 2020) (TRO denied; motion to dismiss pending); Inland Family Practice Ctr., LLC v. SBA (In re Inland Family Practice Center, LLC), Adv. No. 20-06016 (Bankr. S.D. Miss. May 15, 2020) (TRO denied; motion to dismiss pending); Okorie v. SBA (In re Okorie), Adv. No. 20-06015 (Bankr. S.D. Miss. May 15, 2020) (TRO denied; motion to dismiss pending); Abe’s Boat Rentals, Inc. v. Carranza (In re Abe’s Boat Rentals, Inc.), Adv. No. 20-01029 (Bankr. E.D. La. May 13, 2020) (TRO and preliminary injunction denied; motion to convert case under consideration); J.H.J., Inc. v. Carranza (In re J.H.J., Inc.), Adv. No. 20-05014 (Bankr. W.D. La. May 12, 2020) (TRO denied; motion to dismiss pending); Areway Acquisition, Inc. v. SBA (In re Areway Acquisition, Inc.), Adv. No. 20-01037 (Bankr. N.D. Oh. May 12, 2020) (denial of TRO to metal finishing company; motion to dismiss pending).