Using PPP Proceeds as Collateral for Other Loans—Implications for Borrowers and Secured Lenders

Many small business clients have been particularly focused on the PPP because, when the proceeds are used in the manner prescribed by the CARES Act and related rule, the federal government may forgive up to 100% of the PPP loan.

Issues for lenders and PPP borrowers with respect to PPP proceeds as collateral

The authors of PPP have made clear that 75% of the proceeds are supposed to be allocated to payroll expenses, as the main policy objective of PPP is maintaining employment and payroll.  The rule states that “[t]he amount of loan forgiveness can be up to the full principal amount of the loan and any accrued interest” . . . “if the borrower uses all of the loan proceeds for forgiveable purposes described below and employee and compensation levels levels are maintained.”

But what happens when such proceeds end up being used as collateral for an existing loan—whether voluntarily or involuntarily—by the borrower?

Consider this scenario.  A company that has applied for PPP has an existing secured credit agreement in which the secured lender has a security interest in the borrower’s cash.  The borrower obtains a PPP loan and receives, by wire transfer, the loan proceeds.  The proceeds are maintained by the borrower in a comingled account.  Then, the borrower fails to make payment on its senior secured debt, triggering a default and permitting the senior lender to grab or “sweep” the borrower’s existing cash in that account, including the PPP proceeds.  As PPP loans cannot be used to pay principal on other loans (see below), this allocation of PPP proceeds would result in a default under the PPP loan agreement.

This scenario raises several questions, including:

• • While it seems clear that any portion of PPP loan proceeds that are misallocated by the borrower will not be eligible for forgiveness by the government, what other actions will the PPP lender be authorized to take following such a default?
  • Will the PPP loan documents address the subordination of debt and/or other repayment priority issues in connection with the borrower’s existing credit facilities?
  • What actions, if any, could the PPP lender (or borrower) take to recapture PPP proceeds swept from an account by a secured lender?
  • Can PPP borrowers can maintain PPP proceeds in a separate, non-comingled account without triggering a default with its secured lenders with a security interest in cash?

As specific loan documents for PPP loans have not yet been widely circulated, the answers to these questions are not yet clear.  What is clear, however, is that deviations from the rule provisions will result in losing one of the most attractive features of PPP—loan forgiveness.

To obtain forgiveness, the receiving business will have to document exactly how the proceeds are used.  Prudent businesses, therefore, should immediately implement mechanisms at the outset for tracking exactly how PPP benefits are deployed (e.g., to the extent possible, by creating a separate account specifically for PPP proceeds).  If the PPP proceeds are seized by a creditor with a security interest in the borrower’s cash, this may result in losing the loan forgiveness aspect of PPP entirely.

PPP proceeds likely cannot be used as collateral for new debt

Payments made with PPP proceeds for new debt, i.e., obligations incurred after February 15, 2020, are not permitted under the rule—even when for a permitted debt category such as rent payments or mortgage interest.  Small business clients, therefore, hoping to use access to PPP benefits as an inducement to other lenders to secure new financing should be aware that any deviation from the rule may result in the borrower’s losing some or all of the loan forgiveness benefit. Therefore, while access to PPP benefits may be considered by a private lender in deciding whether to advance new or additional credit, small businesses should avoid encumbering the proceeds, especially if they expect to obtain forgiveness from the SBA.

So how can PPP proceeds be used?

PPP is intended to cover payroll, rent, mortgage interest, and utility payments for eligible businesses during the designated period (i.e., February 15, 2020 – June 30, 2020).

The interim final rule for the PPP, which was released earlier this month, provides specific guidance on what the loan proceeds may be used for.  Expenditures can include:

• • payroll costs
  • costs related to the continuation of group health care benefits during periods of paid sick, medical, or family leave, and insurance premiums
  • mortgage interest payments (but not mortgage prepayments or principal payments)
  • rent payments
  • utility payments
  • interest payments on any other debt obligations that were incurred before February 15, 2020; and/or
  • refinancing an SBA Economic Injury Disaster Loan.

Recipients of PPP cash should, therefore, establish protocols now to track exactly how the loan proceeds are used, at the time each expenditure is made.  This will facilitate proving eligibility for loan forgiveness when the time comes to do so.

The SBA Focus Group of the COVID-19 Task Force at Klehr Harrison stands ready to assist you in your business and legal needs. We will continue to provide additional information and guidance as the PPP loan program is implemented.

Author Christopher Leavell is an associate in the Bankruptcy & Restructuring Department at Klehr Harrison.