Federal Court: SBA’s PPP Ineligibility Rule Is Invalid

COVID-19 Update

In a significant rebuke of the Small Business Administration (SBA), a Michigan federal district court has rejected the SBA’s attempt to deem a number of applicants, including sexually oriented dance clubs, ineligible for Paycheck Protection Program (PPP) loans. If broadly adopted, the ruling could have important implications for loan eligibility and for the potential liability of lenders that decline to consider otherwise eligible applicants.

What happened

With limited modifications, guidance concerning the CARES Act’s PPP loan program incorporates existing SBA eligibility rules, which exclude a wide range of businesses—including lenders, insurance companies, political lobbying firms, certain private clubs with restrictive admissions practices, and sexually oriented businesses that present entertainment or sell products of a “prurient” (but not unlawful) nature (the PPP Ineligibility Rule).

In a direct challenge to the PPP Ineligibility Rule, on April 17, 2020, DV Diamond Club of Flint, Michigan, an adult entertainment establishment, and 41 other plaintiffs from across the country (collectively, Plaintiffs) filed an amended complaint against the SBA, its administrator, the United States and Secretary of the Treasury Steven Mnuchin, seeking an emergency temporary restraining order and injunctive and declaratory relief from regulations promulgated by the SBA that restrict certain businesses from receiving PPP loans.

On May 11, 2020, the U.S. District Court for the Eastern District of Michigan granted the preliminary injunction, concluding that the SBA’s PPP Ineligibility Rule restrictions were invalid as contrary to the expansive language of the CARES Act and the purpose of the PPP, which was to deliver a temporary paycheck to support all Americans employed by businesses that satisfied the two eligibility requirements, even those that had been excluded from past SBA loan programs.

When the CARES Act was initially passed, many readers and commentators assumed, based on statutory language broadening the class of eligible borrowers and the motivations behind the act, that the restrictions codified at 13 C.F.R. § 120.110 would not apply to the PPP. However, the SBA’s rules issued on April 15 clarified that the types of businesses identified in Section 120.110 are, in fact, ineligible for PPP loans. The district court disagreed with the SBA and sided with those initial commentators in determining that the language in the CARES Act providing that “any business concern … shall be eligible” shows a clear intent to expand eligibility for PPP loans to certain classes of businesses that are ineligible for traditional SBA loans.

On the grounds that the PPP has limited funds and is funding loans on a first-come, first-served basis, Plaintiffs sought emergency relief, alleging that they have been forced to close or have lost significant business because of the COVID-19 pandemic and could be shut out of the PPP entirely. Because of the SBA rule, lenders denied 33 of the Plaintiffs’ applications, lenders denied two of the Plaintiffs the mere opportunity to submit loan applications, six Plaintiffs submitted loan applications asserting a “reasonable belief” that such loans will be denied, and one of the Plaintiffs was approved but told it may not qualify for loan forgiveness.

The court followed the Chevron analysis of the Administrative Procedures Act by first determining whether “Congress has directly spoken to the precise question at issue” without ambiguity. The question as stated by the court is, “May the SBA exclude from eligibility for a PPP loan guarantee a business concern that (1) during the covered period (2) has less than 500 employees or less than the size standard in number of employees established by the Administration for the industry in which the business operates?” The court determined that Congress had unambiguously answered that question, no, thereby requiring that the SBA rule be invalidated.

The court’s order also points out the SBA’s own apparent recognition of congressional intent to expand the pool of eligible borrowers beyond those in Section 120.110 by allowing certain gambling businesses excluded by that rule to receive PPP loans. However, the court did maintain that eligibility limitations on “businesses engaged in illegal activity” and “businesses located in a foreign country” were inherent in the PPP and, therefore, would not be removed by the court’s invalidation of the SBA’s restrictions.

Notably, the court did not issue the preliminary injunction on a nationwide basis and stated that its order “does not affect in any way actions that Defendants may take in connection with applications for PPP loans by any entity other than the Plaintiffs and Intervenors in this action.” The rest of the businesses in the categories listed in Section 120.110—as well as other businesses threatened by other SBA guidance—are still waiting for more clarity as the PPP runs out of funds.

Why it matters

This is not the first such ruling on the issue. In Camelot Banquet Rooms v. U.S. Small Business Administration, a federal district court in Wisconsin likewise ruled on May 1, 2020, that clubs like DV Diamond were entitled to PPP loans. Unlike the injunction in DV Diamond, the Wisconsin federal court’s injunction was not expressly limited to the litigants, but the Seventh Circuit immediately stayed the injunction pending the SBA’s appeal.

The DV Diamond ruling is clearer in that regard, and does not impose a broader prohibition against the SBA continuing to reject other applicants who fail under the PPP Ineligibility Rule. But the extensive analysis could provide grist for appellate rulings that do have binding and precedential impact. Until that time, lenders should take caution in the receipt and underwriting of PPP applicants who would qualify but for the PPP Ineligibility Rule.

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