Bankruptcy Alert – When PPP Wasn’t Enough: Considerations for Lenders When PPP/EIDL Borrowers File for Bankruptcy

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Travel back in time to the Spring of 2020: people are searching for toilet paper and spraying down their groceries with Lysol. In addition, lenders are tackling the new loan programs created under the CARES Act. Lenders are quickly learning how to process applications for Paycheck Protection Program (PPP) loans and Economic Injury Disaster Loans (EIDL) and navigating an ever-changing landscape of SBA guidance. On the other hand, businesses are crossing their fingers, hoping for approval.

For many businesses, their PPP and EIDL loans may not be enough to carry them through the pandemic. Some businesses are in the same financial positions as in the Spring of 2020 despite receiving the loans.

Many of the PPP and EIDL loans that were issued prior to June 5, 2020, had a maturity date of two years, which means in mid-2022 many lenders, for loans that were not forgiven, will be facing questions of how to deal with defaulting borrowers or borrowers entering bankruptcy. What obligations does a lender have when their PPP or EIDL borrower has defaulted or filed for protection under the Bankruptcy Code?

Treatment of PPP Loans in Bankruptcy: While PPP loans largely did not require collateral or personal guarantees, some EIDL Loans did. In fact, EIDL loans of more than $25,000 required collateral, and EIDL loans greater than $200,000 required personal guarantees.

Generally speaking, PPP and EIDL loans are eligible for inclusion in a business bankruptcy case. PPP and EIDL loans will be treated in bankruptcy according to their security and priority like a typical loan. This means, for most borrowers, a PPP loan is likely to be treated as unsecured debt that can be eligible for discharge.

While the majority of PPP and EIDL loan obligations can be discharged in bankruptcy, this will not necessarily wipe out a lien on any real estate pledged as collateral to a loan. Extra steps are necessary for the borrower-debtor to attempt to extinguish the lien on the real property depending on the type of bankruptcy case filed.

There were efforts to protect lenders under the Consolidated Appropriations Act of 2021 (CAA) that was signed into law on December 27, 2020. The CAA sought to permit certain debtors to obtain PPP funds and also to protect lenders by treating unforgiven PPP loans as super-priority administrative expense claims under sections 364(c)(1) and 503(b) of the Bankruptcy Code. However, these provisions were contingent on the SBA providing a written determination to the Office of the U.S. Trustee that bankruptcy debtors are eligible for PPP loans. The SBA never made such determination. This leaves PPP lenders to be treated as any other lender with their priority determined by their security.

SBA Requirements for Lenders When a PPP Borrower Files Bankruptcy: While PPP and EIDL loans may proceed through the bankruptcy process like any other loan, there are other considerations for lenders. Unlike the typical lender, PPP and EIDL lenders also need to take any required action to ensure the SBA honors its guaranty. So, what does the SBA require of the lender when the PPP and/or EIDL borrower files bankruptcy?

Unless the borrower files a Chapter 7 no-asset case, the lender must provide the SBA with a notice of the bankruptcy filing, file a proof of claim, and continue to monitor the bankruptcy. PPP loans are 100% guaranteed and unsecured, as such the SBA has indicated that while it requires lenders to monitor the bankruptcy, it does not expect lenders to take action in bankruptcy proceedings beyond the minimal actions above. The SBA considers the filing of a proof of claim to be a nominal administrative cost prior to filing the request for purchase and will not reimburse lenders for this expense. The SBA does not anticipate a need for lenders to incur expenses related to litigating the loan. The SBA will generally not approve any additional litigation plans unless the SBA determines there is a reasonable expectation for recovery in excess of legal expenses.

For loans that are secured by collateral, a lender will want to be more involved in its borrower’s bankruptcy. In Chapter 11 bankruptcies the lender will want to particularly concern itself with its treatment under the borrower’s Chapter 11 plan. As with any bankruptcy strategy, there are various considerations in determining what action to take in the borrower’s bankruptcy.

Effect of Bankruptcy on Lender’s Ability to Request a Guaranty Purchase or Charge-Off: Another issue for a PPP and/or EIDL lender to consider is the effect of its borrower’s bankruptcy on its ability to request relief from the SBA. Are there temporal limits on what the lender can request? Can it request a guaranty purchase or charge-off? Can it do so simultaneously?

According to the guidance issued by the SBA, a lender may simultaneously request a guaranty purchase and a charge-off from the SBA under certain circumstances. One of these circumstances is if the borrower files a Chapter 7 bankruptcy petition. If the borrower files a Chapter 11, 12, or 13 bankruptcy, the lender must wait until at least sixty days have elapsed from the end of the PPP loan deferment period or any time after an order is entered confirming a plan if the plan does not provide for payment of 100% of the underlying debt. There are various other circumstances in which a lender may request a guaranty purchase and a charge-off from the SBA, but as they are not bankruptcy related, they are not discussed herein.

Non-SBA Loans and Liens: Many lenders not only made SBA loans to a specific borrower but may have also made non-SBA loans to the same borrower. In this situation, many lenders ask: if assets are liquidated, what priority is the PPP and/or EIDL loan entitled to compared to the non-SBA loans? Do the liens securing these loans have to be satisfied before other non-SBA-related liens?

According to the SBA, the answer is no. SBA loans are not entitled to any special priority if the borrower’s assets are liquidated. If an institution has non-SBA loans to an SBA loan borrower or its principals/guarantors or has liens from any such loans against collateral securing the SBA loan, proceeds from the sale of collateral should be applied based on relative lien priority as may be required by the SBA Loan Authorization.

Servicing Responsibilities: As PPP loans come to maturity this coming year, many borrowers may go through the various stages of default before a bankruptcy is filed, if at all. So, what obligations does a lender have in this stage? At what point do the lender’s servicing responsibilities stop?

According to the SBA, lenders must service PPP loans until they are fully forgiven or paid in full or, in the event of a default or other qualifying event, until the SBA purchases the guaranty and charges off any uncollectable remaining balance.

As part of their servicing responsibilities, PPP lenders are required to:

  1. Keep an accurate record under its direct control of each loan;
  2. Collect and apply loan and forgiveness payments;
  3. Submit separate monthly SBA Form 1502 reports that include loan status information for their PPP loans, regardless of whether the borrower made a payment in the current month or whether the loan is in deferment until the loan is paid in full, fully forgiven, or, if applicable, until the SBA purchases the guaranty on the loan;
  4. Document all loan modifications, including changes of ownership. Note: Borrowers may not receive forgiveness unless the loan details are correct in E-TRAN;
  5. Issue a decision to the SBA in accordance with PPP Loan Program Requirements when the borrower submits a forgiveness application. In the event a borrower does not submit an application for forgiveness within 10 months of the end of the covered period, the lender must communicate with the borrower to determine the status of the business (e.g., whether the business is open, closed, in bankruptcy, etc.) and notify the borrower of the date the first payment on the loan is due. The lender must document communication attempts and results in its files;
  6. If a borrower does not submit a forgiveness application within 10 months of the end of the covered period, or if the PPP loan is partially forgiven or forgiveness on the PPP loan is denied in full, the borrower must make payments in accordance with the note, and the lender must continue servicing the loan until it is paid in full or the SBA purchases the guaranty;
  7. If the borrower becomes more than 60 days past due, the lender should make a demand for payment in full and submit a request for guaranty purchase and charge off through the Platform;
  8. If a balance remains after a lender receives a forgiveness payment from the SBA, the principal and interest reduction from the forgiveness remittance and any loan payments received from the borrower must be reported on the SBA Form 1502 before the lender submits a guaranty purchase request;
  9. If the borrower does not receive full forgiveness on the loan, and the lender receives any post-guaranty purchase payments from the borrower, the lender must send the full payments to the SBA via Pay.Gov (https://www.pay.gov/).

Navigating the bankruptcy process can be daunting and the addition of new types of SBA loans can complicate the process. While it appears that the SBA oftentimes does not require extensive participation in the bankruptcy for the average PPP lender, this strategy may be different for a lender secured by collateral.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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