One Court Reverses Itself and Others Expose Eligibility Loopholes
Several recent bankruptcy court decisions reveal that a temporary restraining order prohibiting the Small Business Administration (SBA) from enforcing its rule that a debtor in bankruptcy cannot qualify for a Paycheck Protection Program (PPP) loan (the Bankruptcy Exclusion) is not necessarily a reliable predictor of ultimate success on the merits, and some courts have permitted end runs around the Bankruptcy Exclusion, empowering debtors to take advantage of those loopholes.
A Brief Refresher Regarding the SBA’s Bankruptcy Exclusion
Congress passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) enacting the PPP, a loan program aimed at helping businesses pay their employees during the pandemic. The PPP is guaranteed under Section 7(a) of the Small Business Act, which authorizes the SBA to provide loans to small businesses. As with other Section 7(a) loans, the SBA made the approval of a PPP loan expressly contingent on the borrower not being “presently involved in any bankruptcy,” even though that requirement is not imposed by the CARES Act.
The PPP, however, is unlike any other Section 7(a) loan program in several important respects. Section 7(a) loans do not contain a forgiveness feature, and the SBA’s guarantee of the loan is limited to 75-85% of the loan amount, leaving the lender at risk for the balance. On the other hand, a PPP loan is 100% guaranteed by the SBA, and if a borrower uses the PPP loan proceeds to fund payroll and other eligible operating expenses during a particular time period, that portion of the loan proceeds (up to 100%) will be forgiven, resulting in the loan becoming a grant. To be clear, the SBA is required to pay to the lender or PPP noteholder that portion of a PPP loan that is forgiven as well as interest on the principal amount so forgiven.
On June 5, 2020, the Paycheck Protection Program Flexibility Act (the Flexibility Act) was enacted. The Flexibility Act makes the PPP friendlier to borrowers and significantly increases the likelihood that the entire PPP loan will be forgiven. Among the improvements are an increase in the amount of time a business has to spend PPP funds and an increase in the percentage of the loan that a business may spend on operating expenses.
The Flexibility Act did not address the Bankruptcy Exclusion adopted through the SBA’s rulemaking authority, despite the abundance of litigation challenging that rule and the mixed results arising from such litigation.
Sometimes a Court Changes Its Mind
In Penobscot Valley Hospital v. Carranza (In re Penobscot Valley Hospital), Case No. 20-1005, and Calais Regional Hospital v. Carranza (In re Calais Regional Hospital), Case No. 20-1006, the Bankruptcy Court for the District of Maine, assessing the merits of complaints filed by two debtor hospitals seeking relief from the Bankruptcy Exclusion, issued proposed findings of fact and conclusions of law supporting the dismissal of the debtors’ complaints despite having previously entered a temporary restraining order (TRO) prohibiting the SBA from enforcing the Bankruptcy Exclusion.
The hospital debtors in Penobscot and Calais filed complaints by way of order to show cause, seeking relief from the Bankruptcy Exclusion. Each of the debtors had been denied access to PPP loan funds on account of their pending bankruptcy proceedings, and alleged that the denial of their loan applications violated: (i) Section 525(a) of the Bankruptcy Code, because the PPP is a “grant” program as opposed to a loan program, and in administering the grant the SBA impermissibly discriminated against bankruptcy debtors; and (ii) the Administrative Procedures Act (APA), because the SBA exceeded its rulemaking authority when it promulgated the Bankruptcy Exclusion. These same arguments have been raised, with varying success, by bankruptcy debtors across the country.
As in other similar cases, the SBA opposed the debtors’ requests for relief and argued that (i) the debtors are barred from seeking injunctive relief against the SBA pursuant to 15 U.S.C. § 634(b); (ii) the PPP is a loan program, not a grant program, and therefore Section 525 of the Bankruptcy Code is inapplicable; and (iii) the SBA’s promulgation of the Bankruptcy Exclusion was a proper exercise of its broad rulemaking authority to formulate and implement rules governing its lending programs, including the PPP.
On April 30, 2020, the court granted TROs over the SBA’s objection. The TROs enjoined the SBA and participating PPP lenders from denying or refusing to guarantee a PPP loan in favor of the debtors solely on the basis of their bankruptcy debtor status. In its opinion supporting the TROs, the court found that the debtors had demonstrated a likelihood of success on their Section 525 claims. More specifically, the court found that “participation in the PPP could be characterized as an ‘other similar grant’” as defined under Section 525(a) and, as such, the SBA’s categorical exclusion of bankruptcy debtors from the PPP violated Section 525’s antidiscrimination provisions.
However, and most unusually, the court reversed course on June 3, 2020, issuing findings of fact and conclusions of law calling for the dismissal of the complaint. The court declined to issue a final binding decision due to its finding that the debtors’ claims under the APA did not invoke issues “core” to the debtors’ bankruptcy proceedings. As to the debtors’ Section 525 claim, the court determined that the PPP is not a “grant” as used in Section 525(a), namely because it initially assumes the form of a loan and it is not akin to instruments previously adjudicated as falling within the scope of section 525(a), like licenses, permits, charters and franchises:
Despite the Debtor’s assertions and notwithstanding some of the preliminary determinations made in the TRO, the PPP is a loan program; it is not merely a grant of aid.
[. . .]
[A] distribution of PPP funds initially assumes the form of a loan. Congress knows how to distribute aid without strings attached and, in fact, did so recently. See, e.g., 26 U.S.C. § 6428(a) (amending the IRC to provide so-called “recovery rebates” as tax credits for certain individuals in the wake of Covid-19). With the PPP, however, Congress elected to establish a loan program, albeit one that does not look like any other loan program available from the government or the capital markets. These loans may function as a grant of aid during a crisis, but they are still—at least at their inception—loans.
[. . .]
The existence of favorable terms and a unique feature (namely, forgiveness under specified circumstances) does not change the character of what the Debtor wants to obtain: a loan that might be forgiven by the lender. The Debtor makes much of the SBA’s concession that it does consider whether an applicant is likely to liquidate before providing a loan number for an application. That does not, in the Court’s view, establish that the PPP is a “grant program” instead of a “loan program.”
Relatedly, and in further support of its finding that the PPP is a loan program, the court equated the Bankruptcy Exclusion to a creditworthiness assessment typical of loan transactions:
Perhaps a person’s status as a debtor presently involved in bankruptcy is a crude measure of creditworthiness, but it is still a measure.
Relying on these findings and an assessment of the SBA’s discretion to formulate rules in loan-making activities, the court found that the Bankruptcy Exclusion was a proper exercise of the SBA’s rulemaking authority and, therefore, did not violate the APA.
The debtors recently filed objections to the court’s findings of fact and conclusion of law, and pursuant to 28 U.S.C. § 157(c)(1), the district court will conduct a de novo review of the bankruptcy court’s findings.
When in Doubt, Go Around the Bankruptcy Exclusion
Although courts are divided on the issue of whether a bankruptcy debtor is eligible for a PPP loan, a number of courts have exposed loopholes affecting the Bankruptcy Exclusion and permitted debtors to take advantage of those back doors. Each of these cases involves one of two sets of factual circumstances: (i) the debtor already received the PPP loan before or during the pendency of the bankruptcy case, and therefore can keep the funds; or (ii) the debtor has already filed for bankruptcy, then voluntarily dismisses the bankruptcy case in order to apply for and obtain PPP funds, and then subsequently refiles the bankruptcy case.
An example of the first category is In re United States of America Rugby Football Union Ltd., 20-10738-BLS (May 13, 2020), in which the Bankruptcy Court for the District of Delaware found that the debtor rugby association could keep the PPP loan it had allegedly applied for prior to its bankruptcy filing—although the timing of the application was disputed by the SBA—and which had been funded while the debtor was “involved in a bankruptcy proceeding.” The court ruled in favor of the debtor notwithstanding the parties’ factual dispute regarding the timing of the loan application and, by implication, the veracity of the debtor’s representations and responses therein.
Similarly, in Gateway Radiology Consultants, P.A. v. Carranza (In re Gateway Radiology Consultants, P.A.), 20-00330-MGW (Jun. 8, 2020), the Bankruptcy Court for the Middle District of Florida permitted a debtor that applied for a PPP loan while involved in a Chapter 11 bankruptcy to keep those funds, despite the debtor’s apparent representation on its loan application that it was not a bankruptcy debtor (a disputed fact), finding that the SBA exceeded its authority “[b]y engrafting onto the Paycheck Protection Program a requirement that Congress chose not to insist on” and also acted arbitrarily and capriciously in doing so.
While this particular end run may expose a debtor and its management to fraud claims and civil or criminal penalties—to the extent a debtor’s responses on its loan application are not truthful—desperate times call for desperate measures, and a debtor may be willing to “roll the dice” in the hope that the SBA will not pursue a remedy against such a debtor, particularly if the debtor uses the loan proceeds to keep its employees working or if a higher court ultimately determines that the Bankruptcy Exclusion is unlawful.
With respect to the second category of end runs, in at least one case a court permitted bankruptcy debtors to voluntarily dismiss their bankruptcy cases, apply for a PPP loan and then reopen the previously dismissed bankruptcy case, in order to circumvent the PPP eligibility rule. See In Advanced Power Technologies, LLC, Case No. 20-13304-PGH (Bankr. S.D. Fla. Apr. 24, 2020); but see In re Capital Restaurant Group, LLC, Case No. 19-65910-WLH (Bankr. N.D. Ga. Mar. 28, 2020) (dismissing bankruptcy case with prejudice and barring debtor from refiling for one year in order to prevent debtor from circumventing Bankruptcy Exclusion).
The Takeaway: It’s the Wild West Out There
Unfortunately, lenders have received conflicting messages from the SBA and courts. On the one hand, the SBA is unequivocally directing lenders to deny PPP loans to applicants involved in a bankruptcy proceeding. On the other hand, courts are all over the map as to the enforceability of the Bankruptcy Exclusion. It is nearly impossible to predict the result of a debtor’s challenge to the Bankruptcy Exclusion. Some courts have passionately defended the interests of debtors, while others have, with equal conviction, sided with the SBA, citing its broad rulemaking authority. Even others, as illustrated above, are susceptible to initially ruling in favor of debtors and then changing their minds at the preliminary injunction phase. The mixed results create confusion for loan applicants, debtors, and participating lenders alike.
What is likely, amid much uncertainty, is that the SBA’s quick rollout of the PPP and the courts’ clashing rulings will engender additional PPP eligibility litigation between debtors and the SBA, at least until the PPP sunsets on June 30. As such, lenders may see other contradictory court decisions to add to the existing uncertainty and confusion.
Future litigation related to the Bankruptcy Exclusion may not be limited to suits between debtors and the SBA, but may extend to lenders. For example, the SBA could ultimately decline to honor its guarantee upon a default, whether a loan was extended pursuant to a court order, in error, or based on a lender’s belief that the Bankruptcy Exclusion is unlawful. In that scenario, a lender would be left shouldering the burdens and risks of the loan unless it prevailed in a lawsuit against the SBA for wrongfully failing to honor its guarantee.
The legal landscape continues to get muddier as more courts issue rulings pertaining to the Bankruptcy Exclusion. For example, the Fifth Circuit recently considered the SBA’s appeal of the Bankruptcy Court for the Southern District of Texas’s TRO entered in Hidalgo County EMS Foundation v. Carranza, (In re Hidalgo County EMS Foundation), Case No. 20-2006 (Apr. 25, 2020) (entering order permitting debtor to resubmit PPP loan application to any lender with the phrase “presently involved in any bankruptcy” stricken from the PPP application and directing the lender and the SBA to consider the application on its merits without any consideration of Hidalgo’s bankruptcy filing). On June 22, 2020, the Fifth Circuit issued a three-page opinion holding that the bankruptcy court in Hidalgo “exceeded its authority” when it enjoined the SBA from enforcing the Bankruptcy Exclusion. The Fifth Circuit found that 15 U.S.C. § 634(b)(1) and “well-established Fifth Circuit law” clearly prohibit courts from issuing injunctions against the SBA. The Fifth Circuit did not address the litigants’ arguments regarding the “validity or wisdom” of the Bankruptcy Exclusion. Even if the Fifth Circuit had weighed in on the propriety of the Bankruptcy Exclusion itself, its decision likely would have had little practical effect on debtor access to the PPP because CARES Act funding for PPP loans expires on June 30.
Given the increasing split among courts, it is not surprising that on June 22, 2020, the same day the Fifth Circuit issued its opinion, the Bankruptcy Court for the District of Vermont and the District Court for the Southern District of Indiana ruled in favor of debtors and issued permanent injunctions against the SBA prohibiting the use of its Bankruptcy Exclusion. See Springfield Hosp., Inc. v. Carranza (In re Springfield Hosp., Inc.), Case No. 20-01003 (Bankr. D. Vt.); USA Gymnastics v. U.S. Small Bus. Admin., Case No. 20-01631 (S.D. Ind.).
Until there is greater certainty in this arena, if any comes at all, lenders should continue to process PPP loan applications in accordance with the SBA’s rules governing eligibility, including the Bankruptcy Exclusion. Failure to follow the SBA’s rules may put a lender at risk of the SBA refusing to honor its 100% guarantee and result in expensive litigation. In any event, lenders must be prepared to field questions from borrowers and to deal with the ambiguities of the PPP.
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