Borrowers filing for bankruptcy is normal, but you must have a good plan and a good bankruptcy attorney to help you get the highest recovery in the shortest amount of time.

This is the first in a four-part series about practical steps to take when a borrower declares bankruptcy. This first article provides an overview of the process from end-to-end. The articles in this series are for informational purposes only and not meant to be legal advice. Consult your local bankruptcy attorney. The law is different in every jurisdiction.

Borrowers who go bankrupt is a reality for private lenders. The key to getting a good recovery in the shortest amount of time is having a plan. This article explains how to analyze your position as a creditor and develop strategies to improve your success. It also covers the actions you can take in advance to mitigate your bankruptcy risk.

The Borrow Files for Bankruptcy

It’s usually not a surprise when a borrower files for bankruptcy. They are behind on payments, late fees are adding up, many times you’ve already entered into a forbearance or two, the foreclosure process has begun, or the foreclosure sale is imminent. When you receive notice of the bankruptcy, ask for the case number. Contact your bankruptcy counsel and execute the plan.

Private lenders run into three types of bankruptcies: chapters 7, 11, or 13. Chapter 7 is a liquidation. In a Chapter 11, the debtor’s objective is to reorganize or liquidate in an orderly manner. In a Chapter 13, a debtor can save his home if he pays off the arrears over a three- to five-year plan while keeping current on mortgage payments.

Your problem is the automatic stay, which is an injunction that comes into play when bankruptcy is filed. It stops creditors from taking any actions to collect their debts, including foreclosure. It is permitted to postpone the foreclosure sale date while finding a solution.

Here’s how to analyze the bankruptcy.

Step 1: Is the automatic stay in effect and does it apply to your collateral? Make sure the entity that filed for bankruptcy owns the property. If the property is owned by another LLC held by the debtor or the property is owned as a non-filing spouse’s separate property, the automatic stay does not apply.

If the debtor had another bankruptcy dismissed within one year before the current bankruptcy, the automatic stay lasts just 30 days. If there are three or more bankruptcies within a year, there is no automatic stay. The debtor may ask the court to reimpose the stay for cause.

The debtor is ineligible for bankruptcy and there is no stay if bankruptcy has been filed in violation of a previous court order or if you filed a motion for relief from stay in a previous bankruptcy but the debtor dismissed the bankruptcy before it was heard.

If you’ve obtained an order granting relief from stay on the same property against the same debtor within the last two years, the automatic stay does not apply.

In all these circumstances, you should not foreclose under the assumption of no stay. File a motion to confirm that the court agrees before proceeding.

Step 2: Do grounds exist to get the bankruptcy dismissed? If the bankruptcy is dismissed, the automatic stay goes away, and you may proceed with the foreclosure.

If the debtor is a corporation or partnership, the governing documents stipulate how a bankruptcy is authorized, whether by a majority, supermajority, or unanimous consent of directors or shareholders. If the entity did not get this approval, then the bankruptcy has been improperly authorized and grounds exist for dismissal.

Second, if the debtor has no realistic possibility of confirming a plan, grounds exist for dismissing the bankruptcy.

Third, if you can present evidence the debtor filed the bankruptcy in bad faith, you can try to dismiss the bankruptcy.

There are limits that determine whether debtors are eligible for certain chapters. For Chapter 13, the limits are unsecured debt of $419,275 and secured debt of $1,257,850. The new Chapter 11 subchapter v was $2,725,625 in non-contingent debt, but the CARES Act temporarily increased this to $7,500,000. Chapter 7 has income limits.

Step 3: Seeking Relief from the Automatic Stay. If the first two steps don’t work, see whether grounds exist for a motion for relief from stay. This is asking the court for permission to lift the stay to foreclose. It is made by motion and can usually get done within 25 to 45 days.

In a Chapter 7, if the debtor has no equity in the property, the grounds exist for relief from stay. In chapters 11 and 13, you must additionally show that the property is not necessary for reorganization.

The bankruptcy code provides for adequate protection payments if there is a decline in the collateral’s value. If the debtor does not make those payments or they turn out to be inadequate, the court can grant relief from stay.

Another category is bad faith or scheme to hinder, delay, or defraud creditors. As explained previously, you’re arguing that the debtor is abusing the bankruptcy system.

If your relief from stay was granted, foreclose as quickly as permissible so the debtor doesn’t play more games. In California, you may foreclose and get paid. If there’s a deficiency, then you have to file a claim with the bankruptcy court. Other jurisdictions may require other steps.

Don’t just file relief from stay to be aggressive. If you do, you lose credibility and may have trouble filing one later when better grounds exist.

Dealing With the Bankruptcy

If the automatic stay applies, there are no grounds to dismiss the case and you’re unable to get relief from stay, then you will have to deal with the bankruptcy.

File your proof of claim. This is a statement of everything owed to you as of the petition date, including late fees, default interest, etc. Include backup, such as the promissory note and the trust deed.

Ask for adequate protection payments if the value is declining. Make sure the plan correctly reflects your claim. Debtors often try to sneak in changes in principal, interest, or the loan term—although this is allowed in a cramdown, where the debtor has enough votes from other creditors to approve the plan. Know how to protect your rights. Beware of lienstripping. That is when the court reduces the amount of your lien to the market value of the collateral. Finally, negotiate with the debtor and see if you can work out a plan that suits both of you.

If you’re stuck in a Chapter 7, a trustee is appointed to sell the property, if there’s enough value. Otherwise, the trustee  will “abandon” the property. The property then reverts to the debtor, and you can foreclose. But abandonment does not lift the automatic stay. You must either wait for the case to close or move for relief from stay.

If the trustee has sold your collateral, the trustee will ask you for a payoff demand. If you’re undersecured, you are entitled to what was owed on the petition date and the deficiency becomes an unsecured claim. If you’re oversecured, bankruptcy law allows you to demand post-petition interest, expenses, late fees, legal fees, etc., to the extent there’s cash available.

 Risk Management Strategies

Some new things are being tried by private lenders to mitigate their risk before bankruptcy. The first is writing into your loan documents that the automatic stay doesn’t apply if the debtor files for bankruptcy. Courts are split on its validity. It is generally not allowed in the original loan agreement but could be valid if put into a forbearance agreement, agreements approved by courts, or confirmed Chapter 11 plans.

Blocking shares or blocking directors are another new idea. You can ask the borrower to put the collateral in an LLC and require the unanimous consent of the board or shareholders to file for bankruptcy. You then appoint your own board member or hold voting shares. You can now, in theory, block a bankruptcy filing.

Check how your jurisdiction treats both these approaches before employing them. In both cases, you would still need to file a motion to confirm that the court recognizes these approaches before foreclosing.

The last recommendation: Move quickly with all steps in the loan process and foreclosure process. You don’t want to be caught with the borrower filing for bankruptcy when you have unrecorded liens or unsent foreclosure notices.

A borrower filing for bankruptcy is a normal part of your business. Be sure you have a good plan and a good bankruptcy attorney to help you get the highest recovery in the shortest amount of time.