$659 Billion Disbursed Without Underwriting, Collateral or Guarantees: What Could Possibly Go Wrong?

If you can look into the seeds of time,
And say which grain will grow and which will not,
Speak then unto me, who neither beg nor fear
Your favors nor your hate.
—William Shakespeare
Macbeth, Act I, Scene 3

The already notorious Paycheck Protection Program (PPP)[1] is part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).[2] $349 billion of PPP funding became available on Friday, April 3, and less than two weeks later all $349 billion was disbursed or committed to being disbursed. Congress then passed legislation adding $310 billion of PPP funding.[3] Several bankruptcy judges have already questioned whether funds disbursed to applicants under the PPP are correctly characterized as loans or are instead grants, reasoning that if PPP funds are properly used, there is no intent the funds disbursed will be repaid.[4]

While this article is written for ABI’s Commercial Fraud Committee, readers should refer to ABI’s Business Reorganization Committee listserve archives starting April 3, 2020, for postings about PPP issues. Discussion about the PPP and related regulations there has been very informative. ABI’s COVID-19 Resources page[5] should also be reviewed for information, analysis and copies of some of the recent bankruptcy court decisions cited in footnote 4.

The PPP is found in Division A, Title I, of the CARES Act, §§ 1101-1114. The PPP has the constructive purpose of providing money to small businesses to enable them to retain and pay employees during the economic turmoil resulting from the appearance of COVID-19 and the related economic contraction caused by government-ordered business closures, social distancing and other factors. Borrowers may use the proceeds of the loans to pay payroll costs (including employee health care plans), interest on commercial mortgage payments, commercial lease payments and utility payments. So long as the borrower uses at least 75 percent of the funds on payroll costs and meets the employment criteria, the SBA will forgive the loan.[6]

In crafting the PPP, Congress largely dispensed with the requirement that lenders underwrite these loans. The PPP falls under the SBA’s section 7(a) loan program (15 U.S.C. 636(a)). 13 CFR 120.150 lists nine lending criteria for SBA loans (other than under the PPP).[7] Distinguish the SBA’s First PPP Interim Final Rule (85 FR 20811),[8] under which loan underwriting is limited to:

1. confirm receipt of borrower certifications contained in the Paycheck Protection Program Application form issued by the Administration;
2. confirm receipt of information demonstrating that a borrower had employees for whom the borrower paid salaries and payroll taxes on or around Feb. 15, 2020;
3. confirm the dollar amount of average monthly payroll costs for the preceding calendar year by reviewing the payroll documentation submitted with the borrower’s application; and
4. follow applicable BSA requirements,

with the standard underwriting required by section 120.150. Eliminating any doubt about the applicable underwriting standards, the First PPP Interim Final Rule states, “[F]or loans made under the PPP, SBA will not require the lenders to comply with section 120.150 [].”

NONRECOURSE.—Notwithstanding the waiver of the personal guarantee requirement or collateral under subparagraph (J), the Administrator shall have no recourse against any individual shareholder, member, or partner of an eligible recipient of a covered loan for nonpayment of any covered loan, except to the extent that such shareholder, member, or partner uses the covered loan proceeds for a purpose not authorized under clause (i).

The First PPP Interim Final Rule also includes the following:

SBA will allow lenders to rely on certifications of the borrower in order to determine eligibility of the borrower and use of loan proceeds and to rely on specified documents provided by the borrower to determine qualifying loan amount and eligibility for loan forgiveness. Lenders must comply with the applicable lender obligations set forth in this interim final rule, but will be held harmless for borrowers’ failure to comply with program criteria;…

PPP funds are available to individuals with self-employment income who file a Form 1040, Schedule C.[11] Notwithstanding a waiver in § 1102(a)(2)(F)(v) of the personal guarantee requirement in 13 CFR 120.160, the Interim Final Rules issued to date do not contain a waiver of personal liability for a self-employed recipient of PPP funds.

The foregoing only scratches the surface of the CARES Act, the PPP and the interim final rules issued to date, but it should provide a general idea of just how “covenant light” the PPP is. No regulated financial institution, indeed no profit-driven lender of any kind, could extend credit on the terms authorized by the PPP and remain in business.

For individual debtors, the structure of the PPP raises questions about discharging PPP loans in bankruptcy. Of course, if the debtor fully complies with the PPP’s requirements, the loan is forgiven and there is nothing to discharge. But what if the debtor does not comply?

Under the PPP, there are two types of noncompliance. The first occurs if the debtor uses more than 25 percent of the loan proceeds for allowed but nonpayroll purposes, e.g., to pay rent. In that circumstance, the loan is not forgiven and the debtor must pay it off over two years. The second occurs if the debtor was either not eligible for a PPP loan or uses the loan proceeds for an improper purpose, e.g., paying principal on a mortgage. In that circumstance, the debtor must immediately repay the loan or the amount used improperly. The SBA has indicated that it will pursue criminal charges for knowing violations of the eligibility and use requirements.

While these issues would seem to be governed by the normal rules governing discharge, there are a few wrinkles. In litigation over the SBA’s refusal to allow bankrupts to participate in the program, a number of courts have held that the PPP is a grant, not a loan.[12] The Springfield Hospital court reasoned that the minimal eligibility requirements, lack of underwriting mandates and generous forgiveness offered by the PPP made the program a grant rather than a loan.[13] By designating the PPP as a grant, the court was able to provide the debtor with relief under the anti-discrimination protections of § 525(a).

The discharge provisions of § 523(a) pertain to whether an individual debtor receives a discharge from debt. If, as held in several opinions arising out of cases in which bankrupt DIPs have applied for PPP funding and been denied, PPP funds are grants as that term is used in §  525(a) and not loans, is § 523(a) even relevant? Similarly, § 727(b) uses the terms “debt,” “debts” and “liability on a claim.” If PPP funding is indeed a grant, and even if an individual debtor is denied a discharge under § 727, is that individual debtor liable for a “grant” rather than a debt or liability on a claim?

What, if anything, can be done, to an individual debtor, under § 523 or 727 for fraudulent conduct pertaining to application for or misuse of PPP funds? The clear intent of the PPP is that the “loans” be forgiven with minimal, if any, confirmation of the accuracy of the information given to support either the original application or the request for forgiveness. The SBA has instructed lenders that they are to rely on the borrower’s certifications and documentation. Is such reliance reasonable, and in all circumstances? Reasonable reliance will probably be a hotly contested issue if § 523 or 727 adversary proceedings based on PPP loans are ever filed.

For entities, the misuse of PPP funds raises different issues. If a debtor misuses the PPP loan, the debtor violates the terms of the PPP and must repay the misused amount. Can the trustee or DIP recover the misapplied funds from the insider? If an insider causes the debtor to misapply the proceeds of the loan, does the trustee have a cause of action, and if so, what is it?

At the time of this writing, the PPP is not yet six weeks old. It would be silly to predict how the courts will characterize the funds disbursed under the PPP in decisions rendered next week, next month or next year. The rollout of the PPP has been chaotic. It is readily apparent Congress, the Treasury Department, the SBA and even the Federal Reserve did not adequately analyze the legislation and its impact. For the moment, it appears there is not a lot for creditors’ bankruptcy litigation counsel to do regarding the PPP. Indeed, after studying the legislation and the interim final rules, I have the distinct impression that “there is no ‘there’ there” for bankruptcy litigators under this program, at least for those not in government. But with $659 billion at issue, thoughtful and creative lawyers may find PPP issues to deal with for a long time to come.

Never make predictions, especially about the future.
―Yogi Berra