Congress passed the CARES Act, which enacted the PPP, a loan

program designed to help small businesses pay their employees during the COVID-19 pandemic. The PPP is 100% guaranteed under Section 7(a) of the Small Business Act. As with other 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. Furthermore, and perhaps more importantly, unlike other 7(a) loans, PPP loans are to be completely forgiven if their proceeds are used to pay employees and permitted operating expenses. Indeed, the PPP was enacted in the belief

that more than a majority of the principal amount of these loans, initially $350 billion, would be forgiven and thereby repaid by the SBA.

Courts Change Their Minds

Courts across the country are split on the enforceability of the PPP bankruptcy exclusion, with some ruling for debtors and others for the SBA. However, until recently, no court had reversed a prior ruling in favor of a debtor.

In Penobscot Valley Hospital v. Carranza and Calais Regional Hospital v. Carranza, the Bankruptcy Court for the District of Maine 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 debtors in Penobscot and Calais sought relief from the bankruptcy exclusion. Each of them had been denied access to PPP loan funds on account of their pending bankruptcies and alleged that the denial of their loan applications violated: 1) 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 2) the Administrative Procedures Act (APA) because the SBA exceeded its rulemaking authority when it promulgated the bankruptcy exclusion.

The SBA countered by arguing that 1) the debtors are barred from seeking injunctive relief against the SBA pursuant to 15 U.S.C. § 634(b); 2) the PPP is a loan program, not a grant program, and therefore Section 525 of the Bankruptcy Code is inapplicable and 3) 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.

On April 30, 2020, the court entered TROs over the SBA’s objection and 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 the debtors had demonstrated a likelihood of success on their Section 525 claims because “participation in the PPP could be characterized as an ‘other similar grant’” as defined under Section 525(a) and, as such, the SBA’s exclusion of bankruptcy debtors from the PPP violated Section 525’s antidiscrimination provisions.

However, the court reversed course on June 3, 2020, issuing findings of fact and conclusions of law calling for dismissal of the complaint. The court determined the PPP is not a “grant” as used in Section 525(a) 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), including licenses, permits, charters and franchises. 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. Relying on these findings and an assessment of the SBA’s discretion to formulate rules in loan-making activities, the court found the bankruptcy exclusion was a proper exercise of the SBA’s rulemaking authority.

Sidestepping the Bankruptcy Exclusion

Although courts are divided on the issue of whether a bankruptcy debtor is eligible for a PPP loan, some courts have exposed loopholes affecting the bankruptcy exclusion and permitted debtors to take advantage of them. These cases involve either 1) a debtor receiving the loan before or during the pendency of a bankruptcy, meaning it can keep the funds, or 2) a debtor filing for bankruptcy then voluntarily dismissing the case in order to apply for and obtain the loan, and thereafter refiling its case.

For example, In re United States of America Rugby Football Union Ltd., the debtor rugby association was allowed to keep the PPP funds 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 in bankruptcy. The Bankruptcy Court for the District of Delaware ruled in favor of the debtor notwithstanding the factual dispute regarding the timing of the loan application and, by implication, the veracity of the debtor’s representations therein.

As 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 to circumvent the PPP eligibility rule. See In Advanced Power Technologies, LLC and In re Capital Restaurant Group, LLC (debtor must wait one year before filing for bankruptcy protection).

Uncertainty Reigns

Unfortunately, lenders have received conflicting messages from the SBA and courts. While the SBA is directing lenders to deny PPP loans to applicants involved in a bankruptcy proceeding, courts are all over the map regarding the enforceability of 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 and participating lenders.

The SBA’s quick rollout of the PPP and the courts’ clashing rulings will likely engender additional PPP eligibility litigation between debtors and the SBA. As such, lenders may see other contradictory rulings added to the existing uncertainty.

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 the loan was extended pursuant to a court order or by false borrower representations. 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 on the bankruptcy exclusion. For example, on June 22, 2020, the 5th Circuit found that in Hidalgo County EMS Foundation v. Carranza, the Bankruptcy Court for the Southern District of Texas, “exceeded its authority” when it authorized the debtor to resubmit a PPP loan application to any lender with the phrase “presently involved in any bankruptcy” stricken from the PPP application, and directed the lender and the SBA to consider the application on its merits without any consideration of the debtor’s bankruptcy filing.

Given the increasing split among courts, it is not surprising that on June 22, 2020, the same day the 5th 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.1

Until there is greater certainty, if any comes at all, lenders should 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 losing the SBA’s 100% guarantee, resulting in expensive litigation. In any event, lenders must be prepared to field questions from borrowers and to deal with the ambiguities of the PPP. •

1. See Springfield Hosp., Inc. v. Carranza and USA Gymnastics v. U.S. Small Bus. Admin.

– By Howard M. Berkower (Partner, McCarter & English) and Franklin Barbosa Jr. (Attorney, McCarter & English)