Even before the COVID-19 pandemic, the United States was experiencing a record-breaking number of bankruptcy filings and foreclosures for the sixth year in a row. While the reason for the increased filings varies from increased consumer spending, reduced interest rates, and less stringent credit lending requirements, it appears that bankruptcy filings are on the rise with no end in sight.
With growing chances of defaulting borrowers filing bankruptcy to avoid repaying their loans, it is more important than ever for lenders to know the ins and outs of bankruptcy to ensure you are repaid in full. It is no secret that filing bankruptcy is a tool in a borrower’s arsenal that borrowers do not hesitate to use to temporarily drag out or halt a foreclosure sale. Borrowers flock to the bankruptcy court to take advantage of the automatic stay that requires creditors to maintain the status quo the minute the bankruptcy petition is filed. The automatic stay prohibits the creditor from taking any action against the debtor (i.e. the borrower), the estate, and the debtor’s property (like the property you took as collateral for the loan). A bankruptcy case has become an inevitable headache that banks and private lenders will face between filing a Notice of Default and recording the trustee’s deed upon sale. While borrowers have a range of bankruptcy chapters to choose from, there has been an unprecedented increase in Chapter 11 filings, which require a more complex set of procedures for borrowers and creditors alike. 2019 was yet another year where Chapter 11 petitions top the charts. As a result, secured lenders like you must deal with a longer and more expensive time period before you will be repaid in full. But it’s not all bad news — contrary to popular myth, your borrower filing bankruptcy does not automatically mean that your lien will be stripped or discharged in its entirety.
Generally, you can and will be paid in full through a bankruptcy case. If the debtor or trustee don’t take any action, you will be able to collect default interest, late fees, principal, attorney’s fees, and other costs — provided, of course, that these charges are included in your loan documents. The vast majority of secured liens can get through bankruptcy unscathed and are paid in full by the collateral being sold in the bankruptcy case or when the lender forecloses after getting relief from stay or the case being dismissed. As always, however, there are some exceptions.
It is important to note that the bankruptcy court will enforce whatever state law governs your loan documents. For example, high rates of default interest in California may be deemed an unenforceable penalty that cannot be charged on the loan under California state law. And if you cannot charge high rates of default interest in state court, then you will not be able to charge that same default interest rate in the bankruptcy court either. If the debtor or trustee file a claim objection or adversary proceeding, you can find yourself fighting to keep the default interest and proving to the court that the default interest is rationally related to the damages you incurred when the borrower defaulted on the loan. Similarly, if your attorney’s fees provision in your note and deed of trust are not broad enough or are subject to a “reasonableness” requirement, the debtor may object to the inclusion of certain fees in your payoff demand in the bankruptcy court. As with most litigation, careful underwriting will prevent headaches in court later on.
On the whole, the general rule is that a secured creditor’s lien “rides through” bankruptcy unaffected. Nevertheless, you should still take affirmative steps to protect your claim, including, but not limited to, filing (1) a Proof of Claim to ensure the debtor, trustee, and judge know how much you are owed as of the date the bankruptcy case was filed, (2) an objection to the debtor’s proposed plan to repay its debts if the plan does not propose to pay you in full, (3) a motion for relief from stay to allow you to continue to foreclose and/or collect against your borrower, and/or (4) an adversary proceeding complaint to deem your debt non-dischargeable so it will exist after the bankruptcy case is closed, especially if you are holding unsecured debt.
Given that the average bankruptcy case (if the borrower is unsuccessful in reorganizing and repaying its debts per the proposed plan terms) is less than one year, having an appropriate strategy in place is crucial to ensuring you are repaid in full and as quickly as possible.
Moreover, as bankruptcy filings continue to increase nationwide, knowing the ins and outs of the bankruptcy court, your rights to be repaid in full per the terms of your loan documents, and your procedural options are more important than ever to ensure you are prepared in the event you become part of the statistics and have your borrower file bankruptcy to halt repayment of your loan. If you are a lender or secured creditor and your borrower filed bankruptcy, contact Kahana & Feld LLP today for a consultation.