In a major rebuke from the Small Business Administration (SBA), a Michigan federal district court has dismissed the SBA’s attempt to deem a number of applicants, including sex-oriented dance clubs, ineligible for program loans. Paycheck Protection (PPP). If widely adopted, the decision could have significant implications for loan eligibility and for the potential liability of lenders who refuse to consider otherwise eligible applicants.

What happened

With limited modifications, the CARES Act PPP Loan Program guidelines incorporate existing SBA eligibility rules, which exclude a wide range of businesses, including lenders, insurance companies, political lobbying groups, certain private clubs with restrictive admission practices, and sex-oriented businesses that present entertainment or sell products of a “lewd” (but not illegal) nature (the PPP ineligibility rule).

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

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

When the CARES Act was originally passed, many readers and commentators assumed, based on the statutory language expanding the category of eligible borrowers and the motivations behind the law, that the restrictions codified at 13 CFR § 120.110 would not apply. not at PPP. However, SBA rules issued on April 15 clarified that the types of businesses identified in Section 120.110 are, in fact, not eligible for PPP loans. The district court disagreed with the SBA and sided with these early commentators in determining that the wording of the CARES Act providing that “any commercial enterprise…shall be eligible” shows a clear intent to Expand PPP loan eligibility to certain categories of businesses that are ineligible for traditional SBA loans.

On the grounds that the PPP has limited funds and funds loans on a first-come, first-served basis, the claimants requested emergency assistance, alleging that they were forced to close or lost significant business due to of the COVID-19 pandemic and could be excluded from the PPP altogether. Due to the SBA rule, lenders denied 33 of the applicants’ applications, lenders denied two of the applicants the mere opportunity to submit loan applications, six applicants submitted loan applications claiming a “belief reasonable” that these loans would be denied, and one of the applicants was approved but said they might not qualify for loan forgiveness.

The court followed the Chevron analysis of the Administrative Procedure Act by first determining whether “Congress has directly ruled on the precise matter at issue” unambiguously. The question as stated by the court is: “Can the SBA exclude from eligibility for a PPP loan guarantee a commercial enterprise that (1) during the period covered (2) has less than 500 employees or less than the size standard by number of employees established by the administration for the sector of activity in which the company operates? The court determined that Congress answered this question unambiguously, Nopethus requiring the invalidation of the SBA rule.

The court order also underscores the SBA’s own apparent acknowledgment of Congress’s intention to expand the pool of eligible borrowers beyond those in Section 120.110 by allowing certain gambling businesses excluded by this rule to receive PPP loans. However, the court held that the eligibility limitations to “companies engaged in illegal activities” and “companies located in a foreign country” were inherent in the PPP and, therefore, would not be removed by invalidation by the SBA Restraints Court.

Notably, the court did not issue the nationwide preliminary injunction and said its order “does not in any way affect actions that defendants may take in connection with PPP loan applications by any other entity.” as plaintiffs and interveners in this action.” The rest of the companies in the categories listed in article 120.110, as well as other companies threatened by other SBA guidelines– are still waiting for more clarity because the PPP is running out of funds.

why is it important

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

the DV Diamond The ruling is clearer in this regard and does not impose a broader prohibition on the SBA continuing to reject other applicants who fail under the PPP ineligibility rule. But the in-depth analysis could provide water for appellate decisions that have binding effect and precedent. Until then, lenders should exercise caution in receiving and underwriting PPP applicants who would qualify in the absence of the PPP ineligibility rule.