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Bankruptcy Courts Reach Conflicting Results Regarding Legality of Bankruptcy Exclusion in SBA Rules Bankruptcy Courts Reach Conflicting Results Regarding Legality of Bankruptcy Exclusion in SBA Rules

Bankruptcy Courts Reach Conflicting Results Regarding Legality of Bankruptcy Exclusion in SBA Rules Implementing Paycheck Protection Program

Paycheck Protection Program Loans Under the CARES Act

The Paycheck Protection Program (“PPP”), adopted as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which passed Congress on March 27, 2020 and was signed by President Trump the following day, provides forgivable loans guaranteed by the government to certain employers, with forgiveness of the loans dependent upon maintaining certain employment levels for the six months following the loan. A second PPP round was authorized in late April and is currently in process.

The SBA’s Exclusion of Debtors in Bankruptcy from PPP Loans

The U.S. Small Business Administration (“SBA”) adopted regulations implementing the PPP in the days following passage of the CARES Act. One of the conditions mandated by the SBA is that a borrower is disqualified from obtaining a PPP loan if its loan application discloses that it is “presently involved in any bankruptcy.” As most recently revised, this rule (the “Bankruptcy Exclusion”) prohibits an entity that is in bankruptcy at any point between submitting the PPP application and receiving the PPP funds from participating in the program. Further, an entity that has applied but then files for bankruptcy must notify the lender and request cancellation of the application. In effect, an applicant is excluded from obtaining a PPP loan if it is currently a debtor in a bankruptcy proceeding, even though post-petition loans in bankruptcy are typically entitled to administrative expense status, to be repaid ahead of all pre-petition creditors, while a loan that was funded prior to a bankruptcy would be an ordinary unsecured obligation not entitled to any priority at all. 
Legal Challenge to the Bankruptcy Exclusion Results in Temporary Restraining Order From Bankruptcy Court in Texas Against Its Enforcement
On April 24, 2020, the United States Bankruptcy Court for the Southern District of Texas in Corpus Christi issued a temporary restraining order (“TRO”) prohibiting the SBA from enforcing the Bankruptcy Exclusion, finding that the debtor had established a likelihood of success on two claims. First, that the Bankruptcy Exclusion was not authorized by the PPP provisions in the CARES Act and therefore exceeded the SBA’s statutory authority, and second, that the exclusion of debtors in bankruptcy constitutes governmental discrimination against debtors, in violation of section 525(a) of the Bankruptcy Code. Hidalgo County Emergency Service Foundation v. Jovita Carranza, In Her Capacity As Administrator for the U.S. Small Business Administration, Adv. Pro. No. 20-2006, (Bankr. S.D. Tex. April 24, 2020).

The TRO does not contain some of the more colorful findings by the court, but media reports indicate that Chief Bankruptcy Judge David R. Jones said from the bench that he saw “no statutory authority” for the Bankruptcy Exclusion. Judge Jones said he considered the question bankruptcy discrimination,” that this cant be what Congress intended,” and that “this cant be how were supposed to treat our fellow man at this time.”[1]

Although Chief Judge Jones granted the TRO, the court declined to grant the full relief requested by the debtor. The debtor requested that the TRO apply to the SBA as a whole, but the court limited its ruling to the debtor’s case. Further, under the Federal Rules of Bankruptcy Procedure, a TRO is a limited order that stays in effect only until the court can conduct a preliminary injunction hearing. In the Texas case, Chief Bankruptcy Judge Jones set the preliminary injunction hearing for May 8.
Similar Results in New Mexico

Bankruptcy Judge David Thuma went even further in a case involving The Roman Catholic Church of the Archdiocese of Santa Fe. Judge Thuma held that the Bankruptcy Exclusion was arbitrary and capricious and therefore violated the Administrative Procedures Act. In an opinion issued on May 1, 2020, Judge Thuma considered the SBA’s justification for the Bankruptcy Exclusion – that bankruptcy debtors “present an unacceptably high risk for an unauthorized use of fund or non-repayment of unforgiven loans.” Judge Thuma stated that this position was “completely frivolous,” noting that a debtor in bankruptcy is subject to far more supervision than an entity outside of bankruptcy. Indeed, he found the SBA’s justification for excluding bankruptcy debtors to be “so weak the Court has to wonder if Defendant really believes it.” The court further found that the Exclusion exceeded the statutory authority of the SBA.

Finally, Judge Thuma found that the Exclusion violated section 525(a)’s prohibition on discrimination. Although the SBA argued that the PPP program is a loan not subject to section 525(a), Judge Thuma concluded that it is, in fact, a grant that is expressly subject to section 525(a).

Judge Thuma also avoided a statutory bar on granting injunctive relief against the SBA by exercising his discretion to enter final judgment immediately invalidating the Bankruptcy Exclusion for the subject debtor. Judge Thuma also suggested in the final judgment that if the Bankruptcy Exclusion ultimately caused the debtor to lose out on the $900,000 in PPP funds that it sought, the debtor would be able to seek compensatory and punitive damages from the SBA.
Bankruptcy Court in Delaware Declines to Issue TRO Against the SBA

Conversely, Bankruptcy Judge Brendan Shannon in Delaware declined to enjoin the Bankruptcy Exclusion excluding debtors in bankruptcy. Judge Brendan Shannon stated that he was dismayed at the consequences that would result for Cosi, Inc., a chapter 11 debtor restaurant chain, but felt constrained to defer to the SBA’s interpretation of the statute.

Judge Shannon reached this result even though Cosi pointed out that another restaurant chain, Florida-based TooJay’s Deli, obtained a PPP loan and then immediately filed for bankruptcy after it had received the funds. This, Cosi, argued, showed the absurdity of the Bankruptcy Exclusion – TooJay’s was able to use the funds as it saw fit and discharge the loan even if it did not meet the criteria for forgiveness, and Cosi would not be able to get the loan at all, simply because it was already in bankruptcy. Judge Shannon urged Cosi to consider an emergency motion to dismiss its chapter 11 case so that it could seek PPP funds, and then presumably refile its chapter 11 case at that point.

Other Challenges Are Anticipated

These cases are likely to be the first of many such cases challenging the Bankruptcy Exclusion. Other cases challenging the Bankruptcy Exclusion are set to be heard soon in the Western District of New York and Eastern District of Kentucky. And, of course, the lawsuit in the Hidalgo County Emergency Foundation case in Texas is not over, given the preliminary and temporary nature of the TRO granted there. And while it appears that companies like TooJay’s have so far succeeded in obtaining PPP loans and then filing chapter 11, it is not yet clear what, if any, steps the SBA may try to take to address these varied situations. So - stay tuned for further developments!

Daniel Anderson is a senior counsel in Ice Miller’s Litigation and Bankruptcy, Restructuring, and Creditors’ Rights Groups, where has a broad base of experience in commercial, securities, and bankruptcy litigation matters.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.   
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