Who CARES Part Deux: Insolvency and the Payroll Protection Program


By Erich M. Paetsch, Partner in the Creditors’ Rights & Bankruptcy and Litigation Practice Groups. (Republished with permission of the Oregon State Bar Debtor-Creditor Newsletter, Vol XXXIX, Number 2, Debtor-Creditor Section, Oregon State Bar 2020)

In the first edition of the 2020 Oregon Debtor-Creditor Newsletter,  this author discussed The Coronavirus, Aid, Relief and Economic Security Act (the “CARES Act”) and a section of the CARES Act commonly known as the Payroll Protection Program (the “PPP”). As previously discussed, The Cares Act requires the Treasury Secretary and the Small Business Administration (the “SBA”) to adopt implementing regulations governing the administration of the PPP. Since April 3, 2020, SBA regulations are regularly issued or clarified, sometimes contradicting earlier guidance.


The size and scope of the PPP combined with significant economic need is creating disputes over eligibility for PPP loans and subsequent forgiveness of the amounts received as businesses struggle with the economic ramifications of COVID 19. Many of these disputes are finding their way into the judicial system. A critical aspect of these disputes is whether PPP funds should be considered a “loan” or a “grant” that does not need to be repaid. While funds for PPP loans are no longer available, the tactics used to obtain eligibility are impacting whether funds received under the PPP are treated as a loan or forgiven as a grant. This article focuses on the evolving approaches used to obtain funding under the PPP throughout the United States and the ensuing challenges creative eligibility attempts cause in seeking forgiveness of a PPP loan.


The Bankruptcy Prohibition to PPP Eligibility


While the regulatory interpretation of the PPP has evolved rapidly over time, the SBA has continuously maintained that an applicant presently involved in bankruptcy is ineligible to obtain funds under the PPP. Regulations adopted by the SBA state that if an applicant or the owner of the applicant is the debtor in a bankruptcy proceeding at the time it submits an application, or at any time before the loan is disbursed, it is ineligible to receive a PPP loan. As a result, SBA’s position remains clear that insolvent debtors currently in bankruptcy are ineligible to receive funds under the PPP.


In response to the regulatory position of the SBA, businesses around the country are pursuing alternative paths to overcome the SBA’s prohibition. For many, access to PPP funding is viewed as the only viable option for a business’s survival. Even if the business is eligible for and receives a PPP loan, it might only survive if the loan is treated as a “grant” and not as a “loan”. The approaches are taken to obtain eligibility primarily consist of two paths. First, some PPP applicants elected to apply and obtain PPP funds before filing bankruptcy or in some cases dismissed a pending bankruptcy and then refiled after dismissal and obtaining a PPP loan. In other instances, existing businesses in bankruptcy have attempted to use the judicial system to obtain enforceable orders requiring the SBA to allow PPP funding. There are numerous examples of each path being actively litigated in courts throughout the United States.


Path One: Fighting for Eligibility in the Courts


Cognizant of the many challenges and risks presented by dismissal, existing debtors in bankruptcy have sought court support in obtaining PPP loans. The outcome of this approach has been mixed with some debtors finding success with the courts and others experiencing adverse rulings preventing access to PPP loan funds. However, any success may be fleeting as opinions are appealed and forgiveness eligibility is subsequently considered.


In the Southern District of Texas, the Honorable David R. Jones issued a temporary restraining order on April 25, 2020, restraining the SBA from limiting Hidalgo County EMS (“Hidalgo”) from participating in the PPP as part of an adversary proceeding. Judge Jones extended the temporary restraining order as a preliminary injunction on May 8, 2020. As a rural ambulance company, the debtor was experiencing a significant decline in revenue while incurring large costs for personal protective gear in response to the growing COVID 19 pandemic in Texas. Obtaining PPP funds as a grant was seen by Hidalgo as crucial to its survival.


In response to Judge Jones’ decision, the SBA appealed to the U.S. District Court for the Southern District of Texas who stayed Judge Jones’ injunction and certified the matter for direct appeal to the U.S. Court of Appeals for the Fifth Circuit. In the only Appellate court decision on the issue, the Fifth Circuit vacated the injunction based on language in the Small Business Act providing that “no…injunction…shall be issued against the “Administrator”. The Fifth Circuit specifically found that the issue in the appeal was limited to the ability to enjoin the Administrator and “not the validity or wisdom of the PPP regulations and related statutes…”


A similar result was obtained by the debtor in the U.S. Bankruptcy Court for the District of New Mexico on May 1, 2020. In a strongly worded opinion, the Honorable David T. Thuma granted the debtor injunctive relief, finding that the SBA had used the flimsiest of justifications to deny debtors in bankruptcy eligibility under the PPP program. The Court went further than Judge Jones by requiring that the Debtor receive a loan for $900,000 and permitting the Debtor to file an adversary and seek compensatorily and, if appropriate, punitive damages. Following entry of a final order, the SBA appealed the decision to the U.S. District Court for the District of New Mexico with the opening briefing due October 22, 2020.


In contrast, other bankruptcy courts have denied requests for injunctive relief against the SBA from the outset. For example, in In re Cosi, Inc., Judge Shannon in Delaware concluded that he lacked authority to enjoin the SBA despite disagreement with the policy position taken by the SBA. On similar grounds, the U.S. District Court for the Western District of New York entered summary judgment in favor of the SBA on the basis that the debtors claimed relief exceeded the authority of the court.


Given the challenges debtors face establishing eligibility for PPP funds, some debtors have sought alternative approaches to demonstrate eligibility with a bankruptcy case pending. For example, while the appeal to the Fifth Circuit Court of Appeals was ongoing, Hidalgo separately elected to pursue an alternative path to PPP funding. Hidalgo also filed a PPP application and specifically answered “no” to the question of whether it was involved in a bankruptcy. As a result, Hidalgo received a PPP loan for $2.5 million dollars. In response, on August 15, 2020, the SBA moved for the appointment of a Chapter 11 Trustee, accusing Hidalgo of fraud in connection with the PPP application. A ruling is pending on the motion. In direct contrast to the pending Hidalgo dispute, a bankruptcy court in Florida permitted a debtor to keep funds despite the allegation that it represented on its loan application is was not a debtor in bankruptcy. Instead, the court found that the SBA exceeded its authority in precluding eligibility to the debtor. This decision is also on appeal.


The election to pursue access to PPP funding through the judicial system has had mixed results. In some cases, initial success has created further complications for existing debtors in bankruptcy. In addition, the litigious path may complicate whether and if funds received are a loan or a grant as discussed below. Whether the PPP funds must be repaid could have important implications for a debtor and its other creditors in a bankruptcy case.


Path Two: Circumventing the SBA Rule


In contrast to obtaining a court-ordered injunction, some debtors elected a different path to eligibility under the PPP. Noting that the SBA rule only applies to debtors in bankruptcy at the time of application, these debtors attempted to avoid the bankruptcy issue altogether. For example, some debtors dismissed pending cases, applied for and obtained a PPP loan, and then refiled or negotiated out of court settlements. In contrast to his earlier opinion, Judge Shannon found that a rugby association could keep a PPP loan allegedly obtained before the bankruptcy petition was filed but funded while the debtor was in bankruptcy. This approach is not without risks as one debtor discovered when a loan was approved, but not funded prior to filing and the Kentucky Bankruptcy Court denied its motion to require turnover of the PPP funds. In at least one reported case conditions imposed upon dismissal by creditors as part of their objections to a strategic dismissal made the benefits of obtaining eligibility less than the costs of an end run s around the SBA’s regulations.


As a coincidence of timing, or perhaps as a planned outcome, some debtors have delayed filing a petition until after a PPP loan is obtained. It is this contingent that will likely grow as the economic impacts of COVID 19 become more apparent and the anticipated increase in bankruptcy filings follows. As experienced bankruptcy practitioners note, the SBA rule and the alternative paths pursued can produce dramatically different results for the SBA under the bankruptcy code. Under the PPP program rules, a PPP loan is initially an unsecured loan without guarantees that can be forgiven if certain conditions are satisfied as discussed in my prior article. When PPP funds are obtained before a bankruptcy filing, a PPP loan is scheduled as a general unsecured loan by a debtor. In contrast, if a PPP loan is obtained post-petition and contrary to the SBA’s rule, the loan is eligible for administrative expense treatment. This contrast in treatment can result in significant differences in the amount and likelihood of repayment in a bankruptcy case. Regardless of which treatment occurs, the question of forgiveness looms large for many debtors.

If PPP funds are obtained by a debtor, the classification of those funds as a loan or grant dramatically impacts some debtors and their creditors in bankruptcy. In cases where payment to a confirmed plan results in no repayment to general unsecured creditors, whether the PPP funds are treated as a loan or grant may have limited importance. If, however, such funds are an administrative expense claim, then whether the funds are a loan or a grant again assumes greater importance.  In cases of a planned reorganization that includes distribution to general unsecured creditors, classification of the PPP funds as a loan or a grant may have critical impacts. The path traveled by a debtor to obtain eligibility for PPP funds may or may not impact whether forgiveness is possible and the subsequent impacts on the success of a debtor in bankruptcy.


Government CARES and Forgiveness


The process and rules surrounding obtaining forgiveness of PPP loans are rapidly evolving with more regulations being adopted to clarify the process for all parties routinely. Structurally, the PPP program is administered within and is part of the SBA’s 7(a) loan program. The PPP program relies upon lenders approving and releasing their funds while complying with SBA’s guidelines, including the bankruptcy question. Approved SBA lenders may seek full reimbursement from the SBA for funds advanced if any portion of the loan is not forgiven or repaid over time. Upon approval, lenders either use recommended forms from the SBA or their own loan documents modified to account for PPP terms. In most cases, the loan documentation for approved PPP loans includes standard terms and conditions with special provisions relating to the PPP. This documentation typically includes standard representations and covenants by the approved borrower and default terms including cross-default terms.


Of utmost importance to PPP, lenders are complying with and preserving the SBA loan guarantee for repayment of the loan. Many lenders participated in the PPP program because of the government guaranty. Absent that guaranty, the PPP loans may not satisfy a lender’s traditional underwriting criteria because of the absence of collateral or personal guarantees. In the absence of other direction from the SBA about PPP loans specifically, lenders are compelled to comply with and follow longstanding SBA 7(a) program rules to avoid loss of the loan guaranty. Among other considerations, a lender must reconcile the SBA program rules and requirements with the language contained in the loan documents when considering an application for forgiveness. In the event of a default, creditors may be required to act to enforce the defaults and deny forgiveness requests to preserve the SBA loan guaranty.

Under the PPP program, lenders are required to initially verify a loan forgiveness application. While the PPP does not impose a clear affirmative obligation to deny forgiveness upon lenders, the program rules do require certification by the lender. After certification, the lender submits the forgiveness application to the SBA for separate approval. In the absence of clear and unambiguous direction, lenders must consider the risk that improper certification might eliminate eligibility for and approval of any demand for repayment from the SBA under the loan guaranty.


A recent case illustrates the challenges both creditors and debtors experience and that the forgiveness question creates. In the case of In re 1069 Restaurant Group, LLC the creditor is seeking repayment in full of the PPP loan in a recently filed chapter 11 bankruptcy petition. The debtor controls roughly 33 Golden Corrals restaurants in Florida and Georgia and received a $9.9 million dollar PPP loan from its existing lender. After receiving the PPP loan, the debtor subsequently defaulted on a $49.7 million mortgage loan obligation. Citing its loan documentation, the lender alleges that because of the cross-default language in the PPP loan documents, the default on the mortgage loan requires repayment of the PPP loan in lieu of forgiveness.


Similar to the cross-default language dispute in In re 1069 Restaurant Group, LLC, the path pursued by a debtor in or prior to bankruptcy for PPP loan eligibility implicates the language and terms of the PPP loan documents signed to obtain PPP funds. Depending on the language in the loan documents, a creditor may be forced to deny forgiveness requests and seek recovery of the PPP loan funds received to preserve access to and eligibility for the SBA loan guaranty. At the same time, for many debtors who obtained PPP funds, the obligation to repay such loans instead of having them forgiven may drive a debtor to file bankruptcy or alternatively may make reorganization less likely.


Depending on the basis for rejection of the PPP forgiveness application, debtors may have several options available to them. If the sole basis for rejection is the filing of a bankruptcy petition, the long history and arguments surrounding so-called ipso facto clauses are triggered. Similarly, debtors may also consider adopting arguments asserted in litigation surrounding PPP loan eligibility that preclusion from forgiveness based solely on bankruptcy violates 11 U.S.C. §525’s anti-discrimination provision. In addition, a careful review of the existing and future SBA regulations relating to the PPP loan program may provide additional arguments.




While the question of PPP loan eligibility is no longer an immediate concern for many practitioners not already involved in active litigation, the path pursued in obtaining a PPP loan will remain an important consideration. As the dispute between creditors and debtors shifts from eligibility to forgiveness, for many lawyers understanding the PPP loan process, eligibility and the underlying policy issues will remain an important aspect of their practice for the foreseeable future.

Erich Paetsch is a partner in the Creditors’ Rights & Bankruptcy and Litigation practice groups. Erich is also a member of the Financial Services and Construction industry teams. The information in this article is not intended to provide legal advice. For professional consultation, please contact Erich here or call  503.399.1070. © 2020 Saalfeld Griggs PC