With bankruptcies on the rise, it is important for lenders to know the ins and outs to ensure full repayment.
As 2019 ended, the number of bankruptcy filings nationwide appear to have increased to a record high for the fifth year in a row. Granted, the number of bankruptcy filings in 2019 surpassed 2018 only by a nominal 0.16%, with the American Bankruptcy Institute reporting 704,414 filings through November 2019 compared to the 703,283 filings through November 2018. Still, as the number of Chapter 11 petitions and bankruptcy filings by former heavyweights such as Forever 21, Payless Shoesource, Barneys New York and Sugarfina increase, the next economic downturn may be just around the corner.
For some areas in the U.S., the downturn may come sooner rather than later. While median real estate list prices are down a few percentage points nationwide, 23 states saw record increases in bankruptcy filings in 2019. Arizona, California, Florida, Georgia, Illinois, Maryland, Michigan, Montana, Oregon and Texas all witnessed increased bankruptcy filings, foreclosures and repossessions in 2019. Montana and Georgia had over 30% more foreclosures statewide in 2019. Foreclosures in San Antonio, Texas; Portland, Oregon; and Tucson, Arizona, were up over 21%; and lenders in Maryland foreclosed on one in every 500 housing units.
Why So Many Bankruptcies?
So, why are we experiencing the record-breaking number of bankruptcy filings and foreclosures that are slowly inching their way up to Great Recession levels?
The American Bankruptcy Institute reported that personal expenditures have steadily increased since 2010, rising over $13.4 trillion by the end of 2019. With these expenditures inevitably comes an increase in consumer debt. As more consumers accumulate debt and fall behind on their payments, bankruptcy can be seen as a way to delay repayment.
Indeed, many experts speculate that the current economic climate can be seen as the result of a combination of increased spending, reduced interest rates, less stringent credit lending requirements, reduced business investment spending and trade conflicts. While the true reason is up for debate, all experts seem to agree that bankruptcy filings are steadily increasing, with no end in sight.
Will I Get Repaid?
With ever-increasing 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 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).
Although borrowers have a range of bankruptcy chapters to choose from, there has been an unprecedented increase in Chapter 11 filings, which involve a more complex set of procedures for both borrowers and creditors. 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, the news is not all bad—contrary to popular myth, if your borrower files bankruptcy, it 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. Most 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.
Interest Rates, Attorney Fees and Lien Stripping
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.
Another myth is that your lien will be stripped (i.e., reduced) any time your borrower files bankruptcy. This is untrue. Debtors can strip or reduce your lien only in certain circumstances, which are by and large not the norm. For example, debtors can only strip a lien when the creditor is undersecured (i.e., the debt owed to the creditor exceeds the fair market value of the collateral). If the property securing your lien has plenty of equity, you don’t need to worry about the debtor successfully stripping your lien.
Furthermore, debtors are prohibited from stripping undersecured liens in Chapter 7 cases and cannot strip first position liens secured by the debtor’s primary residence in a Chapter 11 or Chapter 13 case. Also, in Chapter 11 and 13 cases, debtors cannot strip junior liens secured by the debtor’s primary residence unless the junior lien is totally underwater. In other words, if there’s some value in the property over and above the amount of any lien senior to yours, you don’t need to worry about the debtor successfully stripping your lien. As you can see, the many exclusions on lien stripping prohibit your borrower from reducing your lien balance as soon as a bankruptcy case is filed.
Overall, 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:
- 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.
- An objection to the debtor’s proposed plan to repay its debts if the plan does not propose to pay you in full.
- A motion for relief from stay to allow you to continue to foreclose and/or collect against your borrower.
- An adversary proceeding complaint to deem your debt nondischargeable 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. As Benjamin Franklin said, “By failing to prepare, you are preparing to fail.”