Fast casual restaurant Cosi sued the Small Business Administration on Tuesday, alleging it illegally denied its $3.7 million emergency loan request on grounds that the company is currently undergoing bankruptcy proceedings.

The Charlestown, Massachusetts-based flatbread chain filed a lawsuit on Tuesday in the U.S. bankruptcy court for the District of Delaware, arguing that the company should be eligible, under the CARES Act, to apply for Paycheck Protection Program loans designed to help small businesses keep employees on payroll amid the novel coronavirus.

In a five-count complaint, requesting that the court enjoin the SBA from excluding Cosi and other bankruptcy debtors from access to PPP funds, the food chain alleges that the exclusion is discriminatory, exceeds authority under the CARES Act, and is arbitrary and capricious.

“No law, regulation, or rule of any kind disqualifies, or authorizes the SBA to disqualify, bankruptcy debtors from participating in the PPP,” the complaint states. According to Cosi, holding back PPP funds from companies in bankruptcy runs counter to the stated purposes of the CARES Act.

Cosi filed for Chapter 11 bankruptcy on Feb. 24, before the number of coronavirus cases exploded in the U.S. Under Chapter 11, the company has an opportunity to reorganize its debt and emerge as a viable company without having to liquidate all of its assets and shut down operations.

Cosi is no stranger to utilizing Chapter 11 to protect its assets from its debtors; it had also filed for bankruptcy in 2016 and emerged a year later.

The company, which operates restaurants mostly in the Northeast, has continued to offer pick-up and delivery during the COVID-19 outbreak, but represented to the court that its sales had decreased more than 80% below its pre-filing projections.

One check box

While the SBA has made it clear that it does not permit companies in bankruptcy to apply for PPP funds, the agency is coming under fire in a handful of lawsuits alleging that the agency’s rule discriminates against companies in bankruptcy.

Cosi, in its complaint, cites an April 24 ruling from a Texas judge in the state’s southern district that stripped the SBA of its power to enforce the bankruptcy exclusion, and thereby allowed the plaintiff Hidalgo County Emergency Service Foundation to submit an application for PPP funds.

In Hidalgo, according to Cosi’s complaint, the Texas court rejected and deemed frivolous the SBA’s argument that distribution of PPP funds to debtors in bankruptcy would leave the agency with insufficient control over the debtor’s use of funds. The court described the SBA’s bankruptcy exclusion as discriminatory.

But the SBA and the U.S. Treasury have made it clear that bankrupt companies are not eligible.

The first question on its PPP application asks if the prospective borrower is “presently involved in any bankruptcy.” If the “yes” box is checked, then the loan “will not be approved.”

According to the complaint, Cosi submitted applications through Bank of America and JPMorgan Chase, but was denied by both lenders based on its answer to the bankruptcy application question.

Cosi argues that the CARES Act, which appropriated the first round of $349 billion in loans for the program, never specifically stated that the SBA had to box out companies in bankruptcy.

“However, contrary to both the Bankruptcy Code and its own governing laws and rules, the SBA has, without notice or justification, adopted a position that bankruptcy debtors are ipso facto ineligible to participate in the PPP,” the court filing reads.

While the lawsuit is pending, Cosi is asking that the SBA set aside and be prevented from disbursing the $3.7 million it requested. Cosi is also asking the SBA to reverse its stance by declaring companies working through bankruptcy as eligible for PPP funds.

Why not bankrupt companies?

Harvard Law professor Mark Roe told Yahoo Finance that bankruptcy could “cut a couple of different ways” under the SBA’s language.

“One, is companies that might be able to get out of bankruptcy with the PPP money can’t get it,” he said. “It also gives companies an incentive to not file, or at least not file right away, so that they can get the PPP money and hope that staves off of bankruptcy.”

Cosi argues Roe’s first point: That the CARES Act exclusion compromises the company’s chances for emerging from Chapter 11 reorganization.

But the main challenge for the SBA is parsing businesses struggling as a result of COVID-19 from businesses that happen to be struggling during COVID-19.

With the breadth and duration of the shutdowns, Cosi contends that the SBA cannot make this distinction.

“Prior to the onset, the Debtors were executing their business plan in an attempt to successfully reorganize the company,” the complaint states. “But now, virtually overnight, their income has been reduced to a trickle, severely jeopardizing their chances of reorganizing and remaining in business if the impact of the pandemic continues.”

Barring its bankruptcy proceedings, Cosi claims to have met all of the PPP’s other requirements.

Other companies in Chapter 11 have gotten creative in circumventing the PPP exclusion.

In the U.S. bankruptcy court for the Southern District of Florida, Advanced Power Technologies moved to voluntarily dismiss its own Chapter 11 case to apply for a PPP loan, presumably to then re-file for bankruptcy.

The SBA declined to comment for this story, citing pending litigation. Cosi did not respond to a request for comment and Cosi’s attorneys from firm Cozen O'Connor declined to comment.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

Alexis Keenan is a reporter for Yahoo Finance and former litigation attorney. Follow Alexis Keenan on Twitter @alexiskweed.