The Small Business Administration (SBA) has consistently applied its traditional small business lending qualification criteria to Paycheck Protection Program (PPP) loans — likely because the CARES Act grafted the PPP onto the SBA’s Section 7(a) loan program. But the CARES Act also contemplated that the purpose of the PPP was different from traditional SBA lending programs; the PPP is part economic stimulus and part inducement for businesses to continue to pay employees, landlords and banks notwithstanding the fear that COVID-19 would bring them economic hardship. The extent of SBA authority to decide who is entitled to PPP loans has been the subject of several recent court cases, the most recent of which is an Alaska federal court case involving an applicant in bankruptcy. Other cases either involve applicants that were bankrupt or engaged in “prurient” businesses, both ineligible businesses for loans under SBA traditional lending guidelines. The Alaska ruling adds to a series of conflicting decisions by courts considering the scope of SBA’s authority to deny loans to certain businesses.
In Alaska Urological Inst., P.C. v. U.S. Small Bus. Admin. (AUI), the debtor medical clinic and cancer treatment center filed for Chapter 11 reorganization in the U.S. Bankruptcy Court for the District of Alaska in March of 2020. In May and June of 2020, the debtor applied for PPP loans. Both applications were denied on the grounds it was not eligible under the PPP because it was in bankruptcy. The debtor then brought an adversary action in the bankruptcy court and moved to enjoin the SBA from denying its application. The bankruptcy court granted a temporary restraining order. Upon motion by the SBA, the case was moved to the U.S. District Court, where the District Court judge ruled on summary judgment in favor of the debtor.
Form 2483 (the PPP Loan Application) asks whether “the Applicant [is] presently involved in any bankruptcy” and states that if the answer is yes, the loan will not be approved. The bankruptcy exclusion is incorporated into the first Interim Final Rule (IFR) regarding PPP loans by a general reference to Form 2483, but is not specifically discussed by the SBA until the Fourth Interim Final Rule.
The question at the heart of AUI v. SBA is whether the “bankruptcy exclusion” to PPP eligibility is “arbitrary and capricious,” the standard under which agency decisions may be set aside under 5 U.S.C. § 706(2)(A). In AUI, the SBA argued that the inclusion of the PPP in the SBA’s Section 7(a) loan program imputes Section 7(a)’s requirements onto PPP applicants, in particular, the requirement that “[a]ll loans made under this subsection shall be of such sound value or so secured as reasonably to assure repayment.” Facially, this was a strange argument because the CARES Act expressly provides that creditworthiness is not a requirement for PPP loans. Indeed, a material percentage of PPP loans will not be repaid because the borrowers have gone bankrupt — even though many of the loans could/would have been (at least partially) forgiven if the business remained alive long enough to file for forgiveness. Nevertheless, the SBA relied on its fourth IFR and a declaration from an SBA employee to justify its reasoning for the bankruptcy exclusion. The AUI court concluded that these were post-hoc rationalizations and agreed with the debtor that “the record is devoid of agency reasoning” with respect to applying 7(a) underwriting requirements to PPP applications.
While the AUI decision is undoubtedly good news for Alaskan debtors, there is a split developing among the courts that have considered this question. A growing number of debtors have petitioned courts for injunctive relief similar to that granted in AUI; some have been successful, whereas others have been denied. In these decisions, the consensus seems to be that the bankruptcy exclusion, while harsh, is within the SBA’s authority and not arbitrary or capricious. A number of other jurisdictions agree with the AUI decision (including the Western District of Washington, see Astria Health et al v. U.S. Small Bus. Admin., Case No. 1:20-cv-03109 (W.D. Wa. Jul. 17, 2020)). Courts have also split as to how to handle PPP loan proceeds when the funds were received prior to a bankruptcy filing (see, e.g., Mountain States Rosen, LLC, (Bankr. Wy., Mar. 19, 2020)).
Elsewhere, would-be PPP borrowers have tested the limits of the SBA’s authority to deny PPP applicants based on the borrower’s participation in certain industries. As discussed below, courts in New York and Michigan have disagreed as to whether the SBA can apply Section 7(a) restrictions to bar adult entertainment clubs from receiving PPP funds.
Specifically, some aggrieved PPP borrowers are challenging long-standing SBA lending guidelines that set out a long list of ineligible businesses, including businesses that “[p]resent live performances of a prurient sexual nature.” The plaintiffs in these cases argue that Congress established only two eligibility requirements for PPP loans, and that the CARES Act language “any business concern ...shall be eligible to receive a covered [i.e., SBA guaranteed] loan” (emphasis added) means that any business, not just those that meet other 7(a) requirements, should be eligible for PPP loans. In DV Diamond Club of Flint, LLC v. U.S. Small Bus. Admin., Case No. 20-cv-10899 (E.D. Mich. May 11, 2020), the court agreed, holding that the SBA may not import its historic ineligibility rules into PPP loan eligibility decisions. In Pharaohs GC, Inc. v. U.S. Small Bus. Admin., Case No. 1:20-cv-00665-LJV (W.D.N.Y. June 26, 2020), the court reached the exact opposite result, finding that other sections of the CARES Act contemplated additional PPP eligibility conditions, and therefore the SBA was free to include industry-based restrictions on eligibility. The outcomes of these cases may lead to further challenges to the application of ineligibility rules to the PPP. In particular, the SBA has explicitly barred vendors and service providers who work with cannabis businesses from receiving PPP loans. Challenges to the SBA’s authority by service providers to the industry in states that have legalized cannabis may not be far behind.
We are closely monitoring developments in this space. If you have questions about the interactions between bankruptcy proceedings and CARES Act programs like the PPP, we stand ready to assist.