The Small Business Administration May be Enjoined from Precluding a Bankruptcy Debtor from Obtaining Paycheck Protection Program Loans

By: Inkook Choi

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff


            The Paycheck Protection Program (the “PPP”) provides eligible small businesses hit by the COVID-19 pandemic guaranteed loans to cover certain expenses, including payroll costs, rent, and utilities. The PPP is administered by the Small Business Administration (“SBA”). In Vestavia Hills, Ltd. v. United States SBA, the United States Bankruptcy Court for the Southern District of California held that the SBA could be enjoined from preventing a debtor in bankruptcy from applying for a PPP loan.[i] Vestavia Hills, Ltd. (the “Debtor”), operated a senior resident care center in Alabama.[ii] On January 3, 2020, the Debtor filed a voluntary petition under chapter 11 of title 11 of the United States Code (the “Bankruptcy Code”) with the California bankruptcy court.[iii] Upon the Debtor’s request, the court approved post-petition unsecured financing from its limited partners to sell most of its assets as a going concern to yield the best price.[iv] The Debtor needed funds to operate while it solicited offers, and the buyer obtained regulatory licenses and approvals to operate the facility.[v] In early March, just before the pandemic, the court approved the Debtor’s auction procedures.[vi]

            As a result of the COVID-19 pandemic and related stay-at-home orders, the Debtor’s revenue decreased while costs increased.[vii] Upon the Debtor’s request, the court agreed to delay the auction until July, but the pandemic nonetheless affected the sale and the Debtor’s financing.[viii] On May 4, 2020, the Debtor applied to Comerica Bank for a PPP loan for its payroll, utilities, and mortgage interest expenses.[ix] Comerica, however, rejected the loan application because the Debtor answered “yes” to the question on the PPP application, asking if it was presently involved in a chapter 11 bankruptcy.[x] The Debtor thereafter filed an emergency motion seeking a preliminary injunction enjoining the SBA from imposing its Fourth Interim Final Rule (“IFR”) disqualifying debtors in bankruptcy from obtaining the PPP loans.

            The bankruptcy court first addressed a threshold issue—whether the SBA can avoid judicial review under 15 USC § 634(b)(1).[xi] With no controlling precedent, the court held that enjoining an agency that exceeded its authority is appropriate if the injunction would not interfere with the agency functioning.[xii] The court further noted that the CARES Act (“Act”), which established the PPP, presented an “extraordinary case” that warranted courts’ own interpretation of the statute.[xiii]

            The court then analyzed the language of the Act and concluded that the SBA exceeded its authority by interpreting Congress’s silence to exclude chapter 11 debtors from the PPP in violation of § 706(2)(c) of the Administrative Procedures Act (the “APA”).[xiv] The SBA argued that because the PPP is added to the preexisting § 7(a) loan program, which considers a debtor’s bankruptcy filing history as an underwriting requirement, Congress’s silence about bankruptcy justified adding this requirement to the PPP eligibility.[xv] The court, however, was not convinced because the SBA’s First IFR stated that it will “allow lenders to rely on certification of the borrower in order to determine eligibility,” and that it “will not require the lenders to comply with,” typical underwriting requirements.[xvi] The court also noted that the Act’s express disqualification of debtors in bankruptcy to participate in another loan program demonstrated Congress’s intention to include debtors in bankruptcy in the PPP.[xvii]

            The court held that the SBA also violated § 706(2)(a) of the APA because its First and Fourth IFRs were “clearly illogical and arbitrary and capricious.”[xviii] The SBA’s decision to exclude debtors in bankruptcy was premised on the notion that they present a high risk of using funds for non-covered expenses or nonpayment of unforgiven loans.[xix] Congress, however, did not intend the SBA to consider collectability, and provided only two factors that PPP lenders should consider—whether the borrower was operating on February 15, 2020, and whether the borrower has employees.[xx] Congress required no collateral or a personal guarantee to obtain the PPP loans, which were structured to be completely forgivable if they were used for covered expenses and provided documentation of such to its lender.[xxi] Because the First IFR eliminated the typical underwriting requirements, the court was not persuaded by the SBA’s argument that the “sound value” requirement for repayment assurance of § 636(a)(6) of the Small Business Act warrants its Fourth IFR.[xxii] The court also noted the failure to consider the protections afforded by the chapter 11 bankruptcy process underscored the “flimsiness of its ad hoc justification.”[xxiii]

            The Debtor further argued that the PPP loan qualified as a grant under § 525(a) of the Bankruptcy Code, which protects debtors against discriminatory treatment. The court, however, found that the argument was unlikely to succeed.[xxiv] According to the court, the term “grant” does not refer to an “economic grant,” but instead bears a resemblance to the other terms listed under § 525(a), such as “license,” “permit,” “charter,” and “franchise.”[xxv] As such, the court concluded that denial of access to the PPP does not inhibit the debtor’s access to a fresh start in the same manner contemplated by § 525(a).[xxvi]

            Here, the court suspended the SBA’s ability to deny access to the PPP, recognizing the potential irreparable harm to the Debtor and its residents. [xxvii] Moreover, the court found that the public interest is also in favor of the injunction because enjoining the SBA from continuing to preclude the Debtor’s participation only furthers Congress’s objective in passing the Act.[xxviii] In contrast to the ruling of the U.S. Court of Appeal for the Fifth Circuit in Hidalgo City Emergency Service Foundation v. Carranza barring injunctions in all circumstances,[xxix] the California court, which is not subject to similar binding precedent, issued a preliminary injunctio

[i] See Vestavia Hills, Ltd. v. United States SBA (In re Vestavia Hills, Ltd.), 2020 Bankr. LEXIS 1713 (Bankr. S.D. Cal. 2020).

[ii] Id. at *4.

[iii] Id. at *4–5.

[iv] Id. at *5.

[v] Id.

[vi] Id. at *5–6.

[vii] Id. at *6.

[viii] Id.

[ix] Id. at *6–7.

[x] Id. at *7.

[xi] See id. at *13.

[xii] See id. at *14.

[xiii] Id. at *17–8.

[xiv] See id. at *18–9. (“There is nothing in the PPP insisting that lenders determine whether a borrower is in bankruptcy before approving a PPP loan, or requiring a borrower to certify it is not involved in a bankruptcy proceeding to obtain a PPP loan.”)

[xv] See id. at *19.

[xvi] Id. at *19–20.

[xvii] See id. at *20.

[xviii] Id. at *24–5.

[xix] See id. at *22.

[xx] See id.

[xxi] See id.

[xxii] Id. at *23.

[xxiii] Id. at *24.

[xxiv] See id. at *25–7.

[xxv] Id. at *25–6.

[xxvi] See id. at *26.

[xxvii] See id. at *27.

[xxviii] Id. at *28.

[xxix] See Hidalgo Cty. Emergency Serv. Found. v. Carranza (In re Hidalgo Cty. Emergency Serv. Found.), 962 F.3d 838 (5th Cir. 2020) (recognizing that the Fifth Circuit has "concluded that all injunctive relief directed at the SBA is absolutely prohibited").