Get the most out of the bankruptcy: Understand the risk management strategies you can take prior to granting a loan.

Disclaimer: This article is for informational purposes only and is not meant to be legal advice. Consult your local bankruptcy attorney for your particular situations.

As part of a series of articles discussing strategies for private lenders to deal with bankrupt borrowers, this fourth and final article discusses risk management strategies you can take before granting the loan or prior to the bankruptcy. These strategies may include waiver of the automatic stay, use of special purpose entities, blocking shares and blocking directors, keeping good records, and moving quickly to record documents and serve notices.

Pre-Bankruptcy Waiver of the Automatic Stay

When a borrower files for bankruptcy, an automatic stay goes into effect, stopping and forbidding you from collecting your debt, including foreclosing on the property. There is a trend toward permitting the borrower to waive the automatic stay, but courts are split on its permissibility. Courts that view such waivers negatively say that it is against public policy and defeats bankruptcy’s objective of giving the debtor breathing room.

Courts have ruled that pre-bankruptcy waivers of the automatic stay in the initial loan documents are given the least weight, meaning they’re likely unenforceable. However, pre-bankruptcy waivers of the automatic stay are more likely to be enforced in subsequent agreements (e.g., forbearance agreements or agreements in prior bankruptcies).

Rather than treating such waivers as comprehensive, courts factor in such waivers as part of determining cause to grant relief from stay. They also look at the sophistication of the debtor making the waiver, any consideration received by the debtor for such a waiver, the effect on other creditors, and the feasibility of the debtor’s plan.

For lenders, it certainly does not hurt to put in such a waiver. But it is not automatic. You still must move the court for relief from stay. Do not just proceed without court authorization assuming the waiver to be effective; otherwise, you could face sanctions.

The strongest pre-petition waiver is one given in exchange for a forbearance. Two similar alternatives are to (1) have the borrower agree to not oppose a relief from stay motion or (2) get the borrower to stipulate to facts that support the granting of relief from stay, such as admitting that the borrower has no equity or that your lien is not adequately protected.

Bankruptcy Remoteness Using Golden Shares or Blocking Shares

The idea behind this strategy is to give yourself a vote on whether a borrower should file for bankruptcy. At the initiation of the loan, the borrower creates an SPE (Special Purpose Entity) to hold the collateral asset and the loan. This usually takes the form of an LLC.

Then you can implement this idea in three ways. The first is to give yourself a majority of voting shares so you would have to approve the SPE’s bankruptcy filing. These are called “blocking shares.” The second is writing into the SPE’s governing documents that a creditor or creditors must approve or can block a bankruptcy filing. These are called “golden shares.” The third is putting your own representative on the board of directors who could, again, block a bankruptcy filing.

In all these cases, it’s about gaming the borrower’s corporate governance so that you could, in theory, vote to preemptively block any bankruptcy filing should the need arise. This is controversial, and there is a split of authority, but the trend is against them.

There are two main problems. The first is that even though state law controls corporate governance, federal bankruptcy courts have found it is against public policy to deny corporations their right to bankruptcy protection. Thus, courts have recently ruled that blocking and golden shares are invalid and cannot block an SPE’s right to file bankruptcy.

There is a more dangerous concern regarding board members who represent you in the SPE. Board members have a duty to their shareholders and a vote against bankruptcy with only the interests of the lender in mind violates the board member’s fiduciary duties of care and loyalty. In such a scenario, you and the board member may be liable for breach of those duties.

For these reasons, you may be wasting your time setting up the SPE with these preemptive provisions.

It is a good idea to avoid these strategies for the moment, but they are something to think about and discuss with your counsel depending on your jurisdiction and future developments in the law.

Good Record Keeping

Keeping good records should go without saying. You should have all your records in order. In this era when many states no longer require hard copies and only electronic records, it is easy to keep and maintain good records. During the 2008 crisis, lenders had problems foreclosing and collecting on loans because they simply lost the records. Don’t let that happen to you.

Remember, when a borrower files for bankruptcy, you need to file a proof of claim with the court. Your proof of the loan and the amount due are attached as your “proof” of your claim. In California, this would be a copy of the trust deed and the promissory note. In addition, you need to provide a statement of how much is owed as of the petition date. A professional lender will have a good system that can produce this information instantly.

Move Expeditiously

File documents right away, record trust deeds and liens immediately, and send notices at the earliest legal date. Be proactive; don’t let things linger. As soon as the loan is signed, record your trust deed or similar instrument right away. This goes for deeds of foreclosure and anything similar. Don’t be caught with an unrecorded lien when the debtor files for bankruptcy and that automatic stay comes into effect. There are exceptions for recording after the automatic stay is in place, but if you’re too late, you’ll then have an unsecured claim in bankruptcy.

The same goes for required notices. You’re likely aware that to foreclose, notices need to be served on the borrower. In California, the process takes about 200 days and begins the first day the borrower misses a payment. The lender must advise the borrower of the default. Thirty days later the lender records a notice of default. Ninety days after, the lender records a notice of trustee sale. Then, 21 days later, the auction takes place.

Don’t be late on any of those days. The more advanced you are in the process when the borrower files for bankruptcy, the better your recovery in bankruptcy. For instance, if the borrower files for bankruptcy after the notice of trustee sale is recorded, you may continually postpone the trustee sale indefinitely in the hope that the bankruptcy gets dismissed or relief from stay is granted. You avoid having to restart the process. Follow a system that calendars these dates in your state and ensures all these notices are filed in a timely manner, which means neither early nor late.

Borrowers filing for bankruptcy is inevitable, but you can take steps before you give the loan that can give you an edge should a bankruptcy arrive.