If your company files Chapter 11, what happens to the SBA loan? The short answer is that an SBA loan is just a loan, and it follows the rules of any other commercial loan in bankruptcy. One myth is that SBA loans are somehow special and get different treatment. They aren’t. The Bankruptcy Code gives an SBA loan no special priority, and the government’s right to collect is no stronger or higher on the priority ladder than anyone else’s.
So what is the source of the popular perception that SBA loans are untouchable? Mostly it’s the government guarantee. The SBA guarantees the loan. If the borrower defaults, the bank that made it is insured against the loss. That protects the bank, but that guarantee doesn’t make your loan special. The loan being insured doesn’t mean you can’t discharge it.
The good news is that Chapter 11 can give you an opportunity to work with the SBA to restructure your loan. In a Chapter 11 bankruptcy, the SBA loan can be restructured or modified through the plan of reorganization. A Chapter 11 plan will detail how and when an SBA loan is to be restructured. Some folks will balk at the idea of the business defaulting on its loan and then somehow avoiding its obligation. The Bankruptcy Code gives you a lot of creative tools for restructuring business loans, and each works best under different circumstances. Like many things in a Chapter 11 bankruptcy, it depends. The rights and position of the SBA lender in your Chapter 11 case are going to be determined by how you originally structured your deal.
The Collateral
That starts with the collateral, so pull out the SBA paperwork from your closing. Pay close attention to what the business pledged as collateral. In fact, what happens to the loan in Chapter 11 depends a lot on what the collateral secures. Many times the lender takes a blanket lien. If it’s a blanket lien, that means the loan is secured by everything your business owns. The SBA may file a UCC-1 financing statement against the business assets. The lender may also require a lien against a personal asset, such as a mortgage on the owner’s house. If you said you’d sign a mortgage on the house, you’ve signed a mortgage on the house. You’ve got to read the documents. Two owners with the same loan balance can be in completely different positions, because their collateral arrangements can be completely different. Depending on what the lender has done, the business may be able to manage the collateral for the loan through Chapter 11, but the owner’s personal assets may not be so secure.
Then there is the personal guarantee. An SBA loan will usually involve one, which means that even if the business reorganizes, the owner who signed the guarantee remains personally responsible. In other words, if the company reorganizes successfully, you would still have to repay the loan. The individual can wipe out a personal guarantee by filing personal bankruptcy.
One key point that most don’t understand is that the personal guarantee is distinct from the lien on the property. The personal guarantee is a separate debt. A personal guarantee does not create a lien. Say the SBA has a mortgage on your house and you file a personal bankruptcy. Discharge of the debt does not clear the lien. SBA retains the lien, and could foreclose on your house.
That is why you have to explore all strategies. One approach is to file a personal bankruptcy, discharge the debt personally, and then deal with the SBA directly to resolve the lien by negotiating a discounted payoff. The SBA will negotiate a lower settlement, and how much lower depends on the assets its lien is secured by and the situation of the borrower. You may have to negotiate a lower payoff, but that’s better than having to pay the whole amount on the house or any other personal assets that secure the lien. After the SBA accepts the payment, they release the lien on the house. But an SBA loan is not treated differently than any other commercial loan; so you need to work with the SBA. You can’t expect the SBA to just let you go.
Owners also ask whether the lien can be stripped off of property in a business bankruptcy. That usually depends on the value of the collateral that backs up the loan, and it can mean an enormous difference to your financial situation after bankruptcy. Avoiding liens is one of the powerful tools available in a reorganization. Ok, so the bank took a blanket lien. Section 522 of the Bankruptcy Code lets a debtor avoid certain judicial liens, but a blanket lien is not a judicial lien. The problem with a blanket lien is that it is consensual, and that the debtor can’t avoid it.
Pandemic Funding Works Differently
Pandemic funding works differently. While the Paycheck Protection Program doesn’t require a personal guarantee, the Economic Injury Disaster Loan typically does. You’ll need to look at your specific application to see what you signed. With PPP money, the debt is entirely business debt. That’s the ideal. The company owes money, the owner doesn’t. If the business has to file bankruptcy, the owner isn’t on the hook personally and doesn’t have to file too. With EIDL and other SBA loan programs, the guarantee is usually there, so you would need to file personally.
For an owner who took several kinds of SBA money, there are two buckets to sort out. There is the personal loan bucket, and there is the business loan bucket. Say the company took both PPP and EIDL money. In this scenario, the owner would have to file personal bankruptcy to discharge the personal guarantee on the EIDL. Then the PPP debt will be resolved in the business bankruptcy. The CARES Act also expanded the debt limit for the new Small Business Chapter 11 to $7.5 million. That was a big deal for small businesses.
Chapter 11 Isn’t the Only Path
Finally, Chapter 11 isn’t the only path. Restructuring the loan outside of bankruptcy, or before the bankruptcy is ever filed, may also be an option. Filing bankruptcy is not a prerequisite for restructuring, but I would recommend exploring all your options before making a decision. A business should evaluate its situation, and see if it can negotiate with the SBA lender before resorting to bankruptcy. While the laws are clear on this topic, it can still be a pretty tricky situation and a lot can hinge on knowing how to navigate it.
If you are an owner staring at an SBA loan you can’t pay, the worst thing you can do is ignore it. You could lose your business. You could lose your home. You have to explore your options. Chapter 11 can be a great tool to sort out and restructure business debt. But the owner may have to file personal bankruptcy in order to eliminate his or her personal liability. And an SBA lien can remain, attached to real property, even after the personal debt is discharged. In a Chapter 11 case, bankruptcy protection can give you breathing room to come up with a plan for restructuring the loan. But first, you need to find out where you stand, which means you need to dig up and review your loan documents. Once you understand your position, you can decide how to move forward and what your options are.
