This article focuses on the recent “change of control” guidance1 issued by the SBA to its PPP2 lenders (the “Guidance”) and, more specifically, how that Guidance affects insolvent PPP borrowers when they need to sell assets. As explained in more detail below, the recent SBA Guidance simply does not work when dealing with insolvent PPP borrowers.
Hypothetical, But Common Facts
| The PPP borrower has the following capital structure: | ||||
| Secured Lenders | ||||
| – Senior Secured Bank Debt | $10.000 | |||
| – Subordinated Secured Debt | 5.000 | |||
| $15.000 | ||||
| Unsecured Creditors | ||||
| – PPP Loan | $2.500 | |||
| – Trade Creditors | 5.000 | |||
| $7.500 | ||||
Unable to continue operations, the PPP borrower has a fiduciary duty to maximize the value of its assets for the benefit of its creditors. The PPP borrower therefore runs a sale process in the hopes of obtaining an offer to purchase substantially all of the assets as a “going concern” for at least $22.5 million, which is necessary to fully repay its secured and unsecured creditors. The best offer received is only $12.5 million, clearly much higher than liquidation value, but not enough to fully repay its secured lenders, and not enough to provide any distributions to general unsecured creditors. The PPP borrower is clearly insolvent.
The PPP promissory note provides that it is an event of default if the PPP borrower “disposes of any assets, except in the ordinary course of business, without the lender’s prior written consent.”
Does the insolvent PPP borrower care if it fails to obtain PPP lender approval of the proposed sale and therefore triggers a default under the PPP note? The PPP loan is unsecured, so there are no liens that need to be released by the PPP lender to close and transfer the assets to the purchaser free and clear of liens. If the PPP borrower is selling substantially all of its assets and ceasing operations, why even ask for approval? Most PPP borrowers are afraid of the federal government. Will the SBA refuse to forgive the forgivable amount of the PPP loan (but does that even matter to an insolvent borrower ceasing operations)? Will the SBA punish the borrower for failure to obtain approval by giving its PPP loan application “special scrutiny,” and then somehow elect to pursue the principals of the borrower? Most borrowers prefer to request and obtain prior PPP lender consent to avoid these unknowns.
Pre-October SBA Guidance
When PPP borrowers previously requested PPP lender approval of a sale or transfer of assets prior to the October 2020 Guidance, PPP lenders were not sure how to handle those requests. The PPP loan is fully guaranteed by the SBA, so the SBA is the true party in interest affected by the proposed sale. Should the PPP lender deny approval when the PPP loan is not being fully repaid pursuant to the sale? Does the PPP lender need SBA consent to approve a proposed sale (again, the economic risk falls on the SBA guarantor and not the fully guaranteed PPP lender)? If the PPP lender fails to obtain SBA consent, will the SBA refuse to honor its guaranty to the PPP lender?
October 2020 SBA Guidance
On October 2, 2020 the SBA attempted to clarify these issues by issuing its SBA Guidance to PPP lenders, which covers changes of ownership of PPP borrowers by merger, equity transactions or sales of assets.
The SBA Guidance does not, and cannot, modify the terms of the pre-existing loan and promissory note agreed to by the PPP borrower and the PPP lender. The Guidance does not create a promise, covenant or representation by the borrower that it will not sell its assets without prior lender approval. The note merely provides that, if a borrower does sell assets outside the ordinary course of business without prior PPP lender consent, that will constitute an event of default allowing the lender to exercise the remedies provided for in the note.
The Guidance is a communication from the SBA guarantor to the PPP lender informing the lender (i) when and under what required facts the PPP lender may approve a change of control request on its own and without SBA approval; and (ii) when the PPP lender must first obtain SBA approval before the PPP lender may approve a proposed change of control. The Guidance further explains under what facts and conditions the PPP lender and if required, the SBA will provide that approval:
- If a PPP borrower requests the PPP lender’s approval of a sale of 50% or more of its assets (measured by fair market value), in one or more transactions3, the PPP lender may provide that consent without SBA prior approval ONLY IF:
- the PPP borrower first submits its loan forgiveness application to the PPP lender, and
- the PPP borrower escrows the outstanding PPP loan amount (including the amount reflected as forgivable on the loan forgiveness application) in an account controlled by the PPP lender which, upon completion of the loan forgiveness process, must be used to repay any remaining PPP loan balance.
- If a PPP borrower cannot escrow the outstanding balance of the PPP loan for eventual repayment of any unforgiven PPP loan amount, then the PPP lender may not provide approval of the proposed sale of assets without prior SBA approval;
- The SBA will only provide approval without the required escrow IF the purchaser assumes the entire outstanding PPP loan amount (thereby assuming the risk that the loan forgiveness application or some portion thereof will be denied post-closing).
The SBA Guidance Does Not Work for Insolvent Borrowers
First, there are well-settled priority of payment rules that are inconsistent with the SBA Guidance. Secured lenders with liens on assets are legally entitled to all of the sale proceeds of their collateral until paid in full. If there are unencumbered assets, or there are funds are available after the payment of the secured lenders (oversecured lenders), the PPP loan is a general unsecured loan and has no legal priority in payment over other unsecured claims.
An under-secured lender will never release its liens on collateral if it is not receiving all of the sale proceeds. An under-secured lender will therefore never allow its collateral proceeds to be escrowed for the eventual payment of a “junior priority” unsecured PPP loan. Accordingly, an insolvent PPP borrower cannot practically comply with the escrow requirement to obtain PPP lender approval.
Secondly, purchasers of assets from an insolvent seller will be very reluctant to assume liability for the seller’s PPP loan, even if most or all of the loan is subject to a loan forgiveness application. Yes, the purchaser can require a seller indemnification for this assumption of risk, but an indemnification from an insolvent seller is worthless. If a purchaser is required to assume the PPP loan as part of the purchase price, the purchaser will reduce the cash consideration, thereby reducing funds available to the under-secured lender. Again, no under-secured lender will allow this, and will therefore refuse to release its lien on assets if it is not receiving the full value from the sale of its collateral.
When applied to an insolvent borrower, the SBA Guidance improperly:
- attempts to effectively cause the unsecured PPP loan to “prime” the senior secured liens by forcing the borrower to escrow the secured lender’s sale proceeds, which then must be applied exclusively to the unsecured obligation to the PPP lender; and
- even if the secured lender is oversecured, the Guidance attempts to improperly prefer the payment of the general unsecured PPP loan obligation over other general unsecured loan obligations.
Logically, insolvent PPP borrowers should ignore this guidance issued by the SBA to its PPP lenders. Failing to escrow the PPP loan amount, and failure to obtain prior lender consent to a sale of assets, even if required to avoid an event of default, merely creates an event of default under the unsecured note. The remedies for an event of default provided for under the note generally only allow acceleration of the debt. An insolvent borrower selling the secured lenders collateral should not be overly concerned with a default under an unsecured note. However, if ignored, (1) PPP lenders are concerned the SBA might refuse to honor on its guaranty; (2) borrowers are concerned that ignoring the escrow guidance might affect SBA forgiveness of their PPP loans (which probably does not matter for insolvent liquidating borrowers), or trigger closer scrutiny of their original PPP loan application; and (3) secured lenders of the seller are concerned the SBA might take some action against them for accepting the sale proceeds (legally their collateral) if the borrower ignored the SBA escrow “guidance.”
Solution: File Bankruptcy and Obtain a §363 Sale Order
The SBA Guidance seems to allow the insolvent PPP borrower only one solution choice: file a Chapter 11 bankruptcy proceeding and request the Court approve its proposed sale of assets free and clear of all liens, claims and encumbrances to the purchaser, with all liens, claims and encumbrances attaching to the proceeds of sale pursuant to 11 U.S.C. §363.
In the recent case of Wellflex Energy Partners Fort Worth, LLC pending in the U.S. Bankruptcy Court for the Northern District of Texas, Fort Worth division, (Case No. 20-43267) the Debtor requested authority to sell substantially all of its assets without PPP lender consent and without a PPP loan escrow, and requested authority to pay all of the proceeds of sale to its under-secured lender. The PPP lender objected, implicitly arguing that the Debtor must comply with the SBA required escrow, thereby effectively diverting cash proceeds away from the under-secured lenders, which would then be used for the payment of the unsecured PPP loan. The Court overruled the objection and authorized the sale without SBA/PPP lender approval, and without a PPP loan escrow.
Even if the secured lender is over-secured, and there will be funds available for some, but not full payment of unsecured creditors (i.e. the unsecured debt is the “fulcrum security”), the SBA Guidance still does not work. The PPP loan escrow would effectively prefer and pay the unsecured PPP loan before the payment of other pari passu unsecured creditors, which would violated well-settled priority of payment laws.
结论
The SBA Guidance forces insolvent PPP borrowers, who are trying to maximize the value of their assets through a sale, to file an expensive bankruptcy proceeding and to obtain a sale order of the bankruptcy court.4 Insolvent borrowers, their owners and managers, and even out of court assignees of assets under state law “assignments for the benefit of creditors,” simply do not want to risk the uncertain reaction of the federal government if they ignore what is technically a mere event of default under an unsecured note for failure to request and obtain prior PPP lender/SBA approval.
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1 October 2, 2020 SBA Procedural Notice Control No. 5000-20057.
2 Paycheck Protection Program (“PPP”).
3 By implication, it appears the SBA is allowing the PPP lender to provide its approval of a sale of less than 50% of the assets (at fair market value, in one or more transactions) without an escrow of the PPP loan balance, and without prior SBA approval.
4 In reality, most purchases from an insolvent seller will require a Bankruptcy Court §363 sale order to minimize fraudulent transfer and successor liability risks.
