Can CARES Act loans help a business debtor in bankruptcy?

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Over the past week, I’ve been asked whether there is anything in the CARES Act that can facilitate entrance, DIP, or exit financing for a chapter 11 debtor? The short answer is likely not the longer answer is maybe.

The Act delegates rule making authority to Treasury and the SBA. Given the short timeframe for the programs to be introduced, guidance has come in the form of circulars, FAQs, and forms. Thus, the guidelines are less than clear and incomplete. The forms that borrowers must complete all prohibit obtaining a paycheck protection loan or EIDL loan if (a) the company is presently in bankruptcy or (b) has previously defaulted on any government loan in the past 7 years. Moreover, if the borrower has access to other credit, it cannot typically obtain an EIDL loan, which must be collateralized. Also, unless waived by the Act, standard SBA loan requirements apply to paycheck protection and EIDL loans.

As to paycheck protection loans, there is nothing in the Act that says, “don’t lend to a debtor (or potential debtor) in bankruptcy.” The form loan application says “presently involved in any bankruptcy.” Thus, perhaps it is possible for a business to take out a paycheck protection loans prior to filing bankruptcy. However, given the loans are non-recourse, i.e., not guaranteed, and not collateralized, it does not seem that the SBA wants potential debtors taking out these loans. First, the paycheck protection loans can only be used to cover a limited number of expenses, with 75% of the proceeds dedicated to payroll. Second, if the borrower complies with these requirements, the loan is forgiven (otherwise the loan must be repaid over 2 years, at 1% interest with a 6-month payment deferment). If a borrower obtains a paycheck protection loan, then quickly files for bankruptcy protection, it could use the paycheck protection loan proceeds for whatever purpose it wants, and then discharge the unsecured debt created. Of course, taking out a loan you know (or reasonably believe) you cannot repay, or have no intention to repay, can be deemed fraudulent and render the debt non-dischargeable.

Once in bankruptcy, the case for disqualifying borrowers is less clear, despite the bar in the SBA form loan application. In fact, one might think that if the company retained its workforce in accordance with the Act, a paycheck protection loan would provide a good source of funds to accomplish the Act’s goal, particularly given that the borrower would be under court supervision. A paycheck protection loan as exit financing would not seem to violate the Act so long as the debtor’s bankruptcy proceedings have concluded. This likely means entry of a final decree, as the question asks about involvement in bankruptcy proceedings.

Additionally, as to the mid-size business provisions, the Act specifically states that the recipient is “not a debtor in bankruptcy.” Section 4003(c)(3)(D)(i)(V). Again, it is understandable why the SBA or Treasury would want to be careful about lending money to an entity immediately prior to a bankruptcy filing, but once in bankruptcy, lending to such companies would appear to further the Act’s purpose of providing low cost loans to stabilize businesses and promote employment.

In sum, the Act seems agnostic about the use of paycheck protection loans in bankruptcy. The SBA clearly does not want debtors to be able to obtain loans. However, this seems to create a perverse incentive to obtain the loan, then file bankruptcy. Hopefully, guidance will be issued changing this rule, particularly if more funds are allocated to this program over the coming months.

Jeffrey M. Sklarz, Esq.

Green & Sklarz LLC

One Audubon Street, 3rd Floor

New Haven, CT 06511

Ph. (203) 285-8545 



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