Recent bankruptcy court decisions in In re Hidalgo and In re Cosi Inc. indicate that courts are split on whether the U.S. Small Business Administration and participating lenders can deny Paycheck Protection Program loans to businesses that are debtors in a pending bankruptcy proceeding.

The SBA’s Bankruptcy Exclusion

To assist individuals and businesses struggling due to the COVID-19 pandemic, the federal government passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which enacted 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. Unlike other SBA 7(a) loans for which the SBA guarantees up to 85% of the loan, PPP loans are 100% guaranteed by the SBA and, most importantly, may be fully forgiven if the loan is used for certain payroll and related expenses during the eight-week period beginning on the date the loan is disbursed. 

As with all other SBA 7(a) loans, the SBA made the approval of any PPP loan expressly contingent on the borrower not being “presently involved in any bankruptcy,” even though such condition is not imposed by the CARES Act or the Small Business Act. Specifically, question one of the SBA’s PPP loan application asks whether the applicant is “presently involved in any bankruptcy.” The application further states that if the applicant responds in the affirmative to question one, “the loan will not be approved.” On April 24, the SBA emphasized the prohibition by issuing a new interim final rule, stating that “[i]f 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.”

Prior to the creation of the PPP, most originating lenders monetized their SBA 7(a) loans by selling them to a special purpose vehicle, which then sold interests securitized by such loans to banks and other financial institutions. The originating lenders would then use the proceeds from the sale of the loans to originate new SBA 7(a) loans and thereby “recycle” the proceeds. The SBA’s position has been that permitting companies in bankruptcy to obtain an SBA 7(a) loan would create significant default risk, make the interest in the pools much less attractive to investors and potentially jeopardize the entire funding mechanism. The question is whether PPP loans should be treated differently from other SBA 7(a) loans, particularly because of the 100% government guarantee and the potential for a significant portion of the PPP loan to be forgiven at the government’s expense, resulting in the originating lender and the subsequent investors not having “any skin in the game.” 

A Temporary Bar on Bankruptcy Exclusion Enforcement

Hidalgo County Emergency Service Foundation (Hidalgo), a privately owned South Texas ambulatory company, recently filed a lawsuit against the SBA after Hidalgo’s bank rejected the company’s request for a $2.6 million PPP loan because Hidalgo is and was, at all relevant times, a Chapter 11 debtor. In the lawsuit, Hidalgo sought the entry of a restraining order (i) removing all references to bankruptcy involvement from the PPP loan application; (ii) prohibiting lenders from excluding debtors from PPP loan funds pursuant to the SBA’s prohibition; and (iii) declaring that the SBA’s exclusion of bankruptcy debtors constitutes unlawful discrimination in contravention of the Bankruptcy Code. 

Hidalgo argued two grounds for the restraining order. First, it argued the SBA exceeded its authority when it imposed the bankruptcy prohibition given that the CARES Act and Small Business Act do not contain a similar exclusion. Secondly, the company argued the exclusion meets the definition of unlawful discrimination under Section 525 of the Bankruptcy Code, which states, in relevant part, 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 [the Bankruptcy Code] … solely because such bankrupt or debtor is or has been a debtor under [the Bankruptcy Code].”

The SBA countered by arguing Section 525 of the Bankruptcy Code does not apply to loans and loan guarantees like the PPP, the debtor is barred from seeking injunctive relief against the SBA and the SBA has broad authority to implement measures, such as a bankruptcy exclusion provision, concerning its lending programs.

After a hearing on Hidalgo’s temporary restraining order (TRO) application, the bankruptcy court sided with Hidalgo and entered a TRO permitting Hidalgo to resubmit its PPP loan application to any lender with the phrase “presently involved in any bankruptcy” stricken from the application and directing the lender and the SBA to consider the application on its merits without any consideration of Hidalgo’s bankruptcy filing. In granting such relief, the bankruptcy court said Hidalgo established a likelihood of success on its claims that the SBA exceeded its authority in imposing the bankruptcy exclusion and that the exclusion improperly discriminates against bankruptcy debtors in violation of Section 525 of the Bankruptcy Code. The bankruptcy court agreed the SBA does not have any authority under the CARES Act to impose a bankruptcy exclusion regarding PPP loans. Moreover, the court observed the anti-discrimination provisions set forth in Section 525 of the Bankruptcy Code are applicable to the PPP and the SBA’s bankruptcy exclusion because the PPP “isn’t designed to be a commercial product; it is a support product.” Based on this reasoning, the bankruptcy court confirmed the SBA’s bankruptcy exclusion violates Section 525 because it impermissibly discriminates against bankruptcy debtors. The bankruptcy court took great offense with the SBA’s discrimination against vulnerable bankruptcy debtors while administering a government-sponsored support program:

[T]his can’t be what Congress intended. This can’t be the way that we are supposed to treat our fellow man in this time. It’s inconceivable to me that this distinction could be drawn. The people that need the most help and who have sought protection under our laws are the people who are the targets of discrimination in a government support program; can’t possibly be.

The Bankruptcy Court scheduled a hearing on Hidalgo’s request for a preliminary injunction for May 8.

Relief from Bankruptcy Exclusion Not Guaranteed

Where the decision in the In re Hidalgo case may be a source of optimism for debtors, the Bankruptcy Court for the District of Delaware’s decision in In re Cosi Inc. is a sobering reality check.

Cosi Inc. (Cosi) and related parties (collectively, Chapter 11 debtors) were advised by multiple lenders that they did not qualify for a PPP loan due to the SBA’s bankruptcy exclusion. In response, Cosi commenced a lawsuit against the SBA seeking an order enjoining the SBA from disqualifying Cosi from receiving PPP funds. Cosi’s and the SBA’s arguments largely mirrored those presented in the In re Hidalgo case.

Unlike in In re Hidalgo, however, the Delaware bankruptcy court denied Cosi’s request for relief, finding that the court did not have the authority to enjoin the SBA from enforcing its rules. The bankruptcy court reached this decision notwithstanding its strong disagreement with the SBA’s decision to preclude bankruptcy debtors from receiving PPP loans.

The Takeaway: A Questionable Victory for Debtors

There are a number of pending lawsuits challenging the SBA’s bankruptcy exclusion. With the split in decisions discussed above, it remains to be seen whether courts will defer to the SBA’s bankruptcy prohibition rule or decline to enforce it, although some recent decisions issued after Hidalgo and Cosi indicate that courts, for the time being, are favoring debtors and expanding the availability of PPP loan proceeds to the most distressed businesses. Even if courts were inclined to rule favorably for debtors, however, the victory may come too late for some, as the funds from the second round of the PPP quickly dissipate. Indeed, there may no PPP funds available for debtors by the time courts rule on the debtors’ respective TRO applications, leaving them no remedy for potentially unlawful discrimination. However, the entire SBA 7(a) loan program may be at risk if the courts decide against the SBA on Section 525 grounds.

The relative flux in the law leaves lenders between the proverbial rock and a hard place. Lenders can either deny debtor-applicants proceeds under the PPP in accordance with the SBA’s rules, even if that outcome may be unlawful, or, in the alternative, disobey the government in favor of some notion of the greater good. For the time being, lenders should continue to process PPP loan applications in accordance with the SBA’s directives, including the bankruptcy exclusion, and keep an eye on the evolving legal landscape over the next few days.

Howard M. Berkower is a partner in the New York office of McCarter & English and a member of the firm’s corporate practice. He can be reached at [email protected]

Franklin Barbosa, Jr., an attorney in the Newark, NJ, office of McCarter & English, assists clients with a range of bankruptcy and commercial litigation matters. He can be reached at [email protected].