Debtors Need Not Apply? Continuing Developments on the SBA’s Authority to Deny PPP Loans to Debtor Applicants

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.

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 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[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.

LOOKING TO THE COURTS FOR RELIEF

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.

COURTS GRANTING RELIEF

• Like Judge Jones, Judge Colleen Brown of the Bankruptcy Court for the District of Vermont granted relief to debtor Springfield Hospital Inc., citing the nature of Springfield Hospital’s services, and extended the TRO after learning that the hospital had obtained another $4 million in funding to give the parties time to determine next steps. Since the extension of the initial TRO, the parties have filed substantial briefings in connection with the hospital’s section 525(a) claims and presented oral arguments with respect to those claims. On June 22, having found no material facts in dispute, the court entered an order on summary judgment and a permanent injunction in favor of the plaintiff. In doing so, Judge Brown determined that First Circuit precedent, coupled with the Bankruptcy Code’s own waiver of sovereign immunity, did not preclude her from issuing a “carefully crafted injunction.”
• The Bankruptcy Court for the Western District of Tennessee granted a preliminary injunction to Alpha Visions Learning Academy (lead case: In re Jerry James Skefos). There, following the denial of a PPP loan to non-debtor affiliate Alpha Visions, the bankruptcy court held that the SBA had violated both section 525 and the APA. In a portion of its order that figured prominently in Judge Brown’s Springfield Hospital opinion, the court also held that under Sixth Circuit law, including recent non-bankruptcy related PPP precedent, the SBA was not insulated by sovereign immunity. The SBA has appealed.
• Judge Gregory Schaaf of the Bankruptcy Court for the Eastern District of Kentucky took a position similar to Judge Jones with respect to St. Alexius Hospital (lead case: Americore Holdings LLC), noting that the St. Louis-based hospital provided services to an otherwise underserved and depressed community. The debtor plaintiff’s application was subsequently approved and funded, and the debtor dismissed the adversary proceeding.
• Judge Jones issued a second TRO in the cases of KP Engineering, LLC and its affiliates on May 6. KP Engineering, a construction company in the energy space, filed for bankruptcy in August 2019. KP Engineering filed a plan and disclosure statement just as the COVID-19 crisis was hitting the U.S., and was working toward an exit from bankruptcy. The crisis, however, halted production from foreign suppliers, and has threatened the reorganization. Judge Jones followed the TRO with an agreed preliminary injunction on May 18, which authorized KP Engineering to file a PPP application any time on or after June 12, 2020 with the words “or involved in any bankruptcy” stricken, and requiring the SBA to set aside approximately $2.3 million of program proceeds. The order contains findings noting (1) that PPP funds must be issued within 10 calendar days of loan approval, (2) that all loans under the PPP must fund by June 30, and (3) the SBA’s regulations prohibiting PPP loans to debtors in bankruptcy (but acknowledging “a nationwide split in bankruptcy court decisions concerning this prohibition”). Under the order, the funding of any PPP loan is also conditioned upon the effectiveness of KP Engineering’s plan, which was confirmed on June 12, 2020.
  
  KP Engineering’s plan was expected to become effective on June 22, 2020. Whether the Fifth Circuit’s decision in Hidalgo County EMS will disturb that process remains to be seen. The preliminary injunction is set to expire on June 30, and the court has scheduled a status hearing for the same date. Although the order is not express, the timing suggests that the parties intend for a PPP loan to fund prior to the June 30 expiration of the lending period under the program once the debtor has effectively emerged from bankruptcy protection.
• In the Organic Power bankruptcy, the Bankruptcy Court for the District of Puerto Rico entered a TRO on May 8 permitting the debtor to apply for a PPP loan, which was approved and funded. The SBA filed a motion to dismiss, which has been contested, with the preliminary injunction consolidated with the trial to be heard on June 29.
• The Bankruptcy Court for the District of Arizona granted declaratory relief on June 10, 2020 in the case of PCT International Inc. (lead case: Andes Industries Inc.), finding that the SBA had exceeded its statutory authority in promulgating PPP applications containing the disqualifying language.
• Bankruptcy courts also issued injunctions in the bankruptcy cases of Astria Health (Eastern District of Washington) and NRP Lease Holdings, LLC (Middle District of Florida).

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.

COURTS DENYING RELIEF

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:

• In an early decision that he acknowledged was difficult to render, Judge Brendan Shannon of the Bankruptcy Court for the District of Delaware reluctantly found that the denial of a PPP loan to fast casual restaurant chain Cosi, Inc. was not discrimination forbidden by section 525(a) of the Bankruptcy Code, and that, absent some other applicable Code provision, he simply didn’t have the authority to grant the requested relief. Judge Shannon also noted that unlike the debtor in Hidalgo County EMS, the Cosi debtors were not the sole provider of urgent medical transportation services in a rural area. The court offered to entertain an emergency motion from the Cosi debtors to dismiss their bankruptcy, an offer that has not yet been accepted. A motion to dismiss is pending.
• In a pair of nearly identical TROs, Judge Michael Fagone of the Bankruptcy Court for the District of Maine, echoed Judge Jones, noting the urgent and exclusive nature of the services provided by debtors Calais Regional Hospital and Penobscot Valley Hospital and permitting them to apply for PPP loans without regard to their debtor status. However, after hearing evidence at a May 27 trial, Judge Fagone issued proposed findings of fact and conclusions of law recommending the denial of relief with respect to all counts of the hospitals’ complaint. Judge Fagone noted that while the SBA’s choices may cause seemingly harsh results, they are not illegal.
• Judge Fagone subsequently also denied a TRO to debtor Breda LLC, the owner and operator of a high-end inn, because nothing in Breda’s complaint suggested they were likely to suffer immediate or irreparable harm if they were denied access to a PPP loan. On June 22, the bankruptcy court issued findings of fact and conclusions of law recommending the dismissal of Breda’s complaint. The debtors in a pair of cases consolidated before Judge Fagone, A.S. & B.C. Gould & Sons and M.G. Transport, recently filed an amended complaint, which is pending.
• One district court has also issued an opinion. The dioceses of Rochester and Buffalo, New York, currently debtors in separate bankruptcy cases, bypassed the bankruptcy courts and sought relief directly from the District Court for the Western District of New York. The district court has denied the relief. Subsequently, the SBA filed a motion to dismiss the adversary proceeding, asserting similar bases to those articulated in the Hidalgo County proceeding. A declaration filed by John A. Miller, a senior SBA employee, in support of the motion to dismiss articulated a “time is of the essence” rationale for including the bankruptcy exclusion in the PPP application, noting that a bright-line rule allowed the SBA and potential lenders to avoid the time and expense of an extra layer of inquiry, and also avoided intracreditor conflicts:

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.

• Even before the Fifth Circuit’s order, Judge Jones’ decisions in the Southern District of Texas did not move his colleagues in other Texas bankruptcy courts. Two judges in the Bankruptcy Court for the Western District of Texas have denied TROs to debtors. In the bankruptcy of educational software provider Asteria Education, Inc., Judge Craig Gargotta found that there was no violation that required a restraining order against the SBA. Judge Christopher Mott followed suit in the bankruptcy of a restaurant chain, Trudy’s Texas Star Inc. Judge Mott, while recognizing that this was a harsh result, noted that the SBA had created a bright-line rule disallowing debtors to receive PPP loans. The Bankruptcy Court for the Northern District of Texas denied similar relief in another hospital case, Jack County Hospital District, declining to find that the SBA’s exclusion of the debtor from the PPP was a violation of the automatic stay.
  
  The wave of denials has continued across numerous districts.[2]

EFFECT OF THE CHALLENGES ON OTHER PPP LOANS

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.

• In Elemental Processing LLC, a chapter 11 case involving a cannabidiol processor, the debtor filed for bankruptcy after filing its PPP application, and subsequently also reached an agreement on debtor-in-possession financing. Prior to the filing, allegations of mismanagement had landed operations in the hands of a receiver, which the debtor sought to wrest back through a turnover motion. After contested proceedings, the Bankruptcy Court for the Eastern District of Kentucky determined to leave the case with the receiver, overruling the debtor’s request for approval of the DIP financing, use of PPP proceeds, and the turnover. The agent to Elemental’s pre-petition secured lenders has sought dismissal of the case, asserting among other things that the PPP loan was fraudulently obtained. The dismissal was granted by the court on May 15, pending the filing of a final report.
• In the Longview Power case, a prepackaged bankruptcy, the debtor received approval of its PPP loan prior to its filing for bankruptcy protection. The debtor has not disclosed anything further regarding the receipt of disbursement of the PPP loan proceeds, and the debtor has consensual authority to use cash collateral pending the disposition of PPP loan proceeds, which the debtor presumably has been using to pay employee wages and other permitted expenses. No further details have been disclosed to the court regarding their PPP loan. The debtors’ prepackaged bankruptcy plan was confirmed on May 22.
• In Mountain States Rosen, LLC, the debtor filed for bankruptcy on March 19, 2020—shortly before the CARES Act was signed into law—and subsequently submitted an application for a $3.595 million PPP loan, which was approved and funded on April 17, 2020, and from which certain amounts may have been disbursed. The debtor filed a motion with the Bankruptcy Court for the District of Wyoming on April 21, seeking authorization to use the loan for ordinary course expenses, and to apply those amounts instead of other cash collateral. On May 14, 2020, the bankruptcy court granted the motion, authorizing the debtor to obtain the PPP loan and use the proceeds of such loan to fund necessary expenses, including payroll, benefits, utility payments, and other expenses. A sale process is underway in the bankruptcy.
• In the Northern District of Ohio, Judge Alan Koschik issued a preliminary injunction in favor of Weather King Heating and Air, an HVAC company that had received funds post-petition in connection with an issued PPP loan. Judge Koschik ruled that the SBA was not to rescind, annul, or otherwise alter its prior approval of Weather King’s PPP loan based on its bankrupt status, and that the SBA was to process its application for forgiveness in the ordinary course. Subsequently, the SBA appealed the court’s decision, and also filed a motion for mandatory withdrawal of the case to the district court. No developments have yet occurred at the district court level.
• In several bankruptcies, the bankruptcy exclusion has led the debtor to exit the bankruptcy process altogether, presumably in order to apply for a PPP loan without being “involved in a bankruptcy.” Both the debtors in Advanced Power Technologies, LLC (Bankr. S.D. Fl.) and Capital Restaurant Group (Bankr. N.D. Ga) sought and were granted dismissals on an emergency basis. The Advanced Power case, which had been filed in March 2020, was dismissed without prejudice on April 28, 2020. In Capital Restaurant Group, which was filed in October 2019, the bankruptcy court enjoined the debtor from filing a subsequent Chapter 11 bankruptcy petition for one year from the April 28 dismissal, and has required, among other things, the payment of certain postpetition amounts owed. The court’s conditions to dismissal in Capital Restaurant Group may be due to the duration of the case, and to the expenses the debtor incurred during that period. More recently, the Bankruptcy Court for the District of Maryland granted similar relief in iThrive Health, LLC, and did the same in In re Henry Anesthesia Assoc LLC, in each case to allow the debtor to seek a PPP loan outside of bankruptcy.
  
  In one case, the debtor has sought to reinstate its case following a dismissal and subsequent receipt of a PPP loan. In Starplex Corp. v. SBA (lead case: Blue Ice Investment LLC), the debtor sought a dismissal following a determination that the district court had to finally determine the issues relating to its eligibility for a PPP loan. Following an uncontested dismissal of the bankruptcy and the adversary proceeding, the non-debtor entity applied for and received its PPP funding. On June 5, the debtors moved to reinstate the chapter 11 proceedings, apparently after having their bank transfer the PPP funds into their DIP account. The court has not yet acted on the motion.
• On June 8, 2010, the Bankruptcy Court for the Middle District of Florida issued a memorandum decision granting relief in favor of Gateway Radiology Consultants, P.A., whose post-petition PPP application was approved notwithstanding its debtor status (apparently due to a lender change to the application). The SBA objected after Gateway sought authority from the court to use the PPP loan as post-petition financing. Following an objection from the SBA, the bankruptcy court held that the SBA had exceeded its authority “[b]y engrafting onto the Paycheck Protection Program a requirement that Congress chose not to insist on” and that Gateway’s debtor status was irrelevant. The court entered a preliminary injunction order on June 22.
• Florida-based restaurant chain TooJay’s applied for and closed its $6.4 million PPP loan before filing its bankruptcy petitions in the Southern District of Florida on April 28. The bankruptcy court has approved on an interim basis the ongoing use of the PPP proceeds to fund the debtors’ ongoing operations within the scope of permitted uses under the PPP, with a final hearing currently scheduled for June 25, 2020. Due to the ongoing effects of the pandemic, the TooJay’s debtors have sought expedited bankruptcy court approval of bidding procedures for a sale of substantially all of their assets.
• Educational summer camp company Galileo Learning LLC, whose summer 2020 season is another casualty of the COVID-19 crisis, received a $2.54 million PPP loan on April 13, prior to its May 6 filing in the Northern District of California. Galileo also holds a $500,000 Emergency Injury Disaster Loan that is secured by its assets, including cash collateral. The bankruptcy court has granted interim and final authority for Galileo to apply a portion of its PPP loan to employee-related expenses.
• In the USA Rugby bankruptcy, Judge Brendan Shannon—who previously overruled Cosi, Inc.’s request for a TRO—overruled the SBA’s objection to the debtor’s request to use PPP funds that it had received post-petition. In its objection, the SBA noted the disputed timing of the application—which may have been post-petition—and expressed its concern that an order could be interpreted to “require the SBA to guarantee funds that appear to have been inappropriately obtained pursuant to the PPP.”

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.

• PPP Loan Proceeds as Collateral. PPP loan proceeds may be used only for limited business related expenses. Although the CARES Act contains no express prohibition on the pledging of PPP proceeds as collateral, the use of PPP loan proceeds to pay down other indebtedness is prohibited. If the PPP proceeds in TooJay’s are later applied to other indebtedness those funds may not qualify for forgiveness.
• The Scope of Forgivable PPP Proceed Uses. TooJay’s intends to use the PPP loans to fund only qualified day-to-day operations during the bankruptcy. If the funds have been commingled, however, the application of funds may not be traceable—and TooJay’s already may have inadvertently used PPP funds to make non-exempt payments prior to and during its bankruptcy.
  
  Support for the SBA’s various motions to dismiss suggests that the SBA was thinking about potential creditor issues when it promulgated the PPP applications. Although the CARES Act specifies that PPP loan proceeds may be used only for limited business-related expenses, the declaration filed by Mr. Miller, a senior SBA employee, in the Western District of New York case, implies that this limitation might be binding only on a debtor and not on a debtor’s creditors. Mr. Miller asserted as a reason for limiting a debtor’s access to the PPP that certain creditors, including administrative creditors, could assert claims to the PPP loan funds that would interfere with its authorized uses.

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:

• In the district court’s opinion in the Buffalo and Rochester Diocese cases, the court explicitly held that a bankruptcy court did not have authority to issue a final order on the controversy.
• The Bankruptcy Court for the District of Arizona recognized a similar tension in the Starplex TRO proceedings. There, the court held that the SBA had not violated section 525(a) of the Bankruptcy Code, but also determined that the debtor’s APA claims were non-core, and that the court thus did not have jurisdiction to award preliminary injunctive relief. Rather, the court could only offer findings of fact and conclusions of law on the APA claims to the district court. An uncontested dismissal negated the need to forward any conclusions to the district court.
• The Bankruptcy Court for the District of Maine took a similar view with respect to the APA count in the Calais Regional/Penobscot Valley Hospital proceedings, and chose to issue proposed findings of fact and conclusions of law with respect to the hospitals’ claims rather than entering an order. No further action has occurred in those cases.
• In a trio of consolidated cases (In re Schuessler, In re Steffen, and In re Thull Farms LLC), the Bankruptcy Court for the Eastern District of Wisconsin denied relief with respect to claims arising under section 525 of the Bankruptcy Code, but sent the non-core matters, together with its recommendation to deny relief, to the district court, which has not yet ruled.

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.

HOW WE CAN HELP

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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For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Forceto 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. If you would like to receive a digest of all new updates to the page, please subscribe now to receive our COVID-19 alerts.

CONTACTS

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Philadelphia
John C. Goodchild, III
Andrew T. Budreika
Benjamin W. Stango

New York
Kristen V. Campana
Craig A. Wolfe
Melissa Y. Boey

Boston
Sandra J. Vrejan
Andrew J. Gallo
Edwin E. Smith

[1] (Docket Number SBA-2020-0021)

[2] 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).