Get the most out of the bankruptcy: Know your rights and what you can and can’t do.

As part of a series of articles discussing strategies for private lenders to work with bankrupt borrowers, this piece examines options for getting the most out of your claim during bankruptcy proceedings.

When a borrower files for bankruptcy, the automatic stay comes into force. It prevents private lenders from taking legal actions, such as foreclosure, to collect on their loan. The previous article analyzed the actions a lender can take immediately when a borrower files for bankruptcy.

This article focuses on how to get the most out of your claim if you’re stuck in the bankruptcy, including filing a proof of claim, adequate protection payments, verifying that your claim is correctly reflected in the debtor’s plan, cramdown and lien stripping, abandonment, and sale of the collateral property.

Proof of Claim

A proof of claim is your filing with the court demanding what the debtor owes you, backed up by evidence. Proofs of claim are relatively easy to put together and file. There is a form, with instructions, on the U.S. Court website. Along with the court form, submit the debtor’s statement of everything owed to you as of the petition date, including late fees, default interest, etc. Include the promissory note and the deed of trust.

Many courts allow creditors to file electronically, and it is possible to do so without an attorney. However, you still should consult local bankruptcy counsel to make sure what you’ve filed is correct.

Filing a proof of claim should be your first step. Always file one! Although there are exceptions when one is not necessary, don’t bother with those and make a mistake. Just file it. Be aware there is a filing deadline, depending on the bankruptcy chapter. In theory, you’re supposed to receive notice of this deadline. Given that filing is a relatively straightforward and inexpensive process and you already have all the backup handy in your system, just go ahead and file early.

Adequate Protection Payments

If you tried to move for relief from stay and were unsuccessful, you should have asked for adequate protection at the same time. Adequate protection refers to the payments to secured creditors that protect them from a diminution of their collateral during the bankruptcy when they are unable to get relief from stay and foreclose. Adequate protection payments are more likely to be granted when the secured creditor has a small equity cushion.

Carefully Monitor Your Claim in the Plan

The goal of chapter 11 or chapter 13 bankruptcy is to confirm a plan to pay creditors. When the debtor files the plan, make sure it correctly reflects your claim, including the principal, interest, term, etc. If you find any inconsistencies, contact the debtor’s counsel to fix the errors and object to the plan, if necessary. Don’t let the debtor slip one by you by changing the terms of the debt without your consent. Once a plan has been approved, it is too late to object.

Cramdown/Lien Stripping

In some instances in chapters 11 and 13, the debtor can force a change to your claim through the plan. This is called cramdown or lienstripping. You will receive notice of a cramdown and can either object to the cramdown or vote against the plan.

A cramdown in chapter 13 is really the partial stripping of a lien from a secured debt. A debtor can split an undersecured mortgage into two pieces and reduce the lien to the secured portion. The unsecured part joins the pool of other unsecured claims.

For instance, let’s say you’ve lent the debtor $1,000,000 on a home. The home is now worth $800,000. That means the loan is underwater, and $200,000 is unsecured. The chapter 13 debtor can split, or bifurcate, that debt into an $800,000 secured portion and a $200,000 unsecured portion. Your lien is stripped down to cover only the $800,000, and the remaining $200,000 becomes an unsecured debt. A debtor makes payments to the unsecured creditors as a whole. Your portion is the pro-rata share of the total unsecured amount owed. Any unpaid portion at the end of the chapter 13 plan is discharged, which means gone forever. However, your lien on the $800,000 survives the bankruptcy.

Before you get too nervous, there are restrictions. It cannot be done on the debtor’s primary residence. That means the debtor is usually only cramming down his investment properties. Second, in California, the lien can be stripped if the secured portion of the loan is completely paid off during the 3- to 5-year chapter 13 plan.

For chapter 11, the debtor divides its creditors into classes who, as a whole, vote to accept or reject a plan. Debtors may force or cramdown the plan on a non-accepting class, subject to restrictions.

The plan must be “fair and equitable” to the non-accepting class. For a non-accepting secured creditor, like a mortgage holder, a fair and equitable plan keeps the lien in place and provides cash payments with a present value equivalent to the value of the collateral. Another fair and equitable plan sells the collateral property with a lien attaching to the proceeds. A third way is to give the indubitable equivalent of the creditor’s secured interest. You’ll rarely see this, and it’s not well defined, but it may be the offering of a lien on another property.

In both chapters 11 and 13, make sure your rights are protected under the plan and the cramdown of your secured claim follows the rules and restrictions.

Abandonment

As you recall, a chapter 7 trustee is appointed to gather the debtor’s assets and liquidate them for the benefit of creditors. Property that has no value to the estate or is too burdensome will be “abandoned” back to the debtor.

When calculating the value to the estate, you must include the debtor’s exemption. For example, California now offers debtors a $300,000 to $600,000 exemption on their primary residence, depending on the county. A $1,000,000 property with an $800,000 loan would not have $200,000 in value to the

estate, because that equity is exempted. As such, there is no benefit to the estate for selling the property.

So, maybe you were unable to get relief from stay because the debtor had equity in the property, but there was no value to the estate because of the exemption. In this case, the chapter 7 trustee will likely abandon the property back to the debtor. It is very important to remember that abandonment does not end the automatic stay! To foreclose, you must wait for the case to close or move for relief from stay.

Sale of the Collateral Property

It is good news when the debtor decides to sell the property. While it is not as fast as a foreclosure, sales lead to higher prices.

The debtor or trustee will hire a broker to market the property. Moreover, the sale is subject to overbid at the hearing approving the sale. A secured creditor may even use what it’s owed as a “credit bid.” As a secured creditor, bankruptcy law allows you to recover your costs to the extent you’re oversecured. The trustee or debtor will ask you for a payoff demand. Make sure you include post-petition interest, expenses, late fees, legal fees, etc.

Be vigilant of your claim in an ongoing bankruptcy. Know your rights. Know what you can and can’t do.

The next article in the series will discuss risk-management strategies you can take before granting the loan, or prior to bankruptcy.

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