By Rose Krebs

Law360 (April 30, 2020, 4:04 PM EDT ) A Delaware bankruptcy judge on Thursday denied Cosi Inc.'s Chapter 11 bid for an order that would clear the way for it to seek federal coronavirus payroll protection funds, saying that although he is "dismayed" with Cosi's financial plight, he lacked authority to grant its request.

During a teleconference, U.S. Bankruptcy Judge Brendan L. Shannon denied Cosi's bid for a temporary restraining order to bar the U.S. Small Business Administration from disqualifying the restaurant chain from applying for a loan through the Paycheck Protection Program established by the federal Coronavirus Aid, Relief, and Economic Security Act.

The judge said that although he disagrees with the SBA's decision to preclude bankruptcy debtors from receiving PPP money and is "dismayed at the consequences" and harm that will be caused to Cosi by denying its bid for relief from the court, he would defer to a recent directive from the SBA as to how loan funds are to be disbursed.

In a rule posted Tuesday, the SBA clarified some issues over which businesses are eligible to receive loans under the PPP.

"If the applicant or the owner of the applicant is the debtor in a bankruptcy proceeding, either at the time it submits the application or at any time before the loan is disbursed, the applicant is ineligible to receive a PPP loan," the rule states.

Also, if an applicant files for bankruptcy after submitting its PPP request "but before the loan is disbursed, it is the applicant's obligation to notify the lender and request cancellation of the application."

Failure to do so "will be regarded as a use of PPP funds for unauthorized purposes," the rule said.

On Tuesday, Cosi filed an adversary suit in its Chapter 11 against the SBA, asserting that its reorganization plans are in jeopardy due to its inability to obtain PPP relief to ease its financial woes amid the public health crisis.

Cosi contends that the agency has, "without notice or justification, adopted a position that bankruptcy debtors" are not eligible to receive loans under the program.

"The SBA's discrimination based solely on an applicant's status as a debtor is legally unsupported, arbitrary and capricious, and runs completely counter to the stated purposes of the CARES Act and the PPP," the complaint says. "Accordingly, the debtors bring this complaint seeking a declaratory judgment, a writ of mandamus, and related relief to compel the SBA to allow them to participate in the PPP."

Under the program, businesses reeling from the financial impact of the COVID-19 pandemic can seek forgivable loans of up to $10 million. Cosi says it has been tripped up in its attempt to receive a roughly $3.7 million loan because of the lender application process, with prospective lenders telling the company its loan request will be rejected because the chain is in bankruptcy.

Judge Shannon agreed with Cosi's contention that it is precisely the type of business the CARES Act is intended to help, but said the SBA was "clear" that it considers debtors ineligible to seek PPP relief.

In the rule, the SBA said it was determined "that providing PPP loans to debtors in bankruptcy would present an unacceptably high risk of an unauthorized use of funds or non-repayment of unforgiven loans."

Cosi's attorney John K. McDonald of Cozen O'Connor argued Thursday that the SBA's exclusion of debtors from receiving relief is discriminatory and that the agency is exceeding its authority beyond what was intended by Congress when it passed the CARES Act.

McDonald asserted the SBA's policy is "poorly" construed and has created a confusing situation in which some debtors have dismissed cases solely so they can seek PPP loans, or in other cases where a debtor filed for bankruptcy days after applying for a PPP loan.

Marc S. Sacks of the U.S. Department of Justice's Commercial Litigation Branch asserted Cosi wrongly interpreted certain issues of administrative law in its bid for a TRO.

"This court does not have statutory power to enjoin the agency," he asserted.

Even if there have been some problems with debtors who have already sought PPP funds, Sacks said the SBA made it clear in its recent rule debtors are excluded from getting the relief.

He called Cosi's injunctive relief request "brazen," arguing the casual restaurant chain is trying to say it knows better than the SBA how to run the program.

In court filings, Cosi asserts that the impact of the public health crisis is putting its Chapter 11 reorganization in peril and the PPP funds are needed to avoid making things even worse.

Judge Shannon pondered if Cosi would consider an emergency move to dismiss its Chapter 11 so it can seek the PPP funds, telling the company to keep the court apprised if it does want to change course given its current financial plight.

Cosi hit Chapter 11 in February after shuttering 30 stores and looking to reduce rental costs while maximizing profits on its catering business. It is the Boston-based restaurant chain's second trip into bankruptcy in three years, after it emerged from a Massachusetts Chapter 11 case in May 2017.

In a first-day declaration filed with its most recent Chapter 11, before the virus reached pandemic proportions, company vice president Vicki Baue said its restaurant operations had been facing the same negative trends affecting the entire casual dining industry. During that time, however, its catering business had seen growth and presented an opportunity for continued profitability, the declaration said.

A representative for the SBA declined to comment Thursday. Counsel for Cosi did not immediately respond to requests for comment.

Cosi is represented by Mark E. Felger, Simon E. Fraser and John K. McDonald of Cozen O'Connor.

The SBA is represented by Marc S. Sacks, Ruth A. Harvey and Margaret M. Newell of the DOJ's Civil Division.

The bankruptcy case is In re: Cosi Inc et al., case number 1:20-bk-10417, in the U.S. Bankruptcy Court for the District of Delaware.

The adversary case is Cosi Inc. v. Small Business Administration et al., case number 1:20-ap-50591, in the same venue.

--Additional reporting by Joyce Hanson and Vince Sullivan. Editing by Adam LoBelia.

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