Monday, April 13, 2009

Workouts 101: Bankruptcy Basics and the Problem With Non-Monetary and Loan Maturity Events of Default

CRE lenders who have led sheltered lives often believe the events of default listed in their deed of trust and loan agreements will allow them to foreclose on a property if a breach occurs. A material adverse change in the borrower’s financial condition? Unauthorized subordinate liens? The loan has matured? Let’s foreclose!

Sorry, it doesn’t work that way. Here are some bankruptcy basics (and I mean really basic; feel free to skip sections if you know about the topic headlined).

The Automatic Stay

If a borrower file bankruptcy, your foreclosure is automatically stayed. From the US Courts website, Bankruptcy Basics-Chapter 11:

The automatic stay provides a period of time in which all judgments, collection activities, foreclosures, and repossessions of property are suspended and may not be pursued by the creditors on any debt or claim that arose before the filing of the bankruptcy petition. As with cases under other chapters of the Bankruptcy Code, a stay of creditor actions against the chapter 11 debtor automatically goes into effect when the bankruptcy petition is filed. 11 U.S.C. § 362(a)… The stay provides a breathing spell for the debtor, during which negotiations can take place to try to resolve the difficulties in the debtor's financial situation.

Lifting the Automatic Stay

How do you get your foreclosure going again? You need to file a motion to lift the stay:

Under specific circumstances, the secured creditor can obtain an order from the court granting relief from the automatic stay. For example, when the debtor has no equity in the property and the property is not necessary for an effective reorganization, the secured creditor can seek an order of the court lifting the stay to permit the creditor to foreclose on the property, sell it, and apply the proceeds to the debt. 11 U.S.C. § 362(d).

It is very difficult to obtain relief from the automatic stay if there is equity in the property. The bankruptcy judge determines if there is equity or not based on evidence presented by the lender and the borrower. The lender presents an appraiser who thinks the value is low, the borrower presents an appraiser who thinks the value is high, and typically the judge decides somewhere in the middle. At this point in the cycle it is not hard for a borrower’s appraiser to support a high value given the value downturn has just started, so in most cases lenders will have a tough time getting relief from stay.

Adequate Protection

So you can’t foreclose. How long might this go on? The best case is for single asset entity real estate debtors (other debtors get longer to file a plan):

On request of a creditor with a claim secured by the single asset real estate and after notice and a hearing, the court will grant relief from the automatic stay to the creditor unless the debtor files a feasible plan of reorganization or begins making interest payments to the creditor within 90 days from the date of the filing of the case, or within 30 days of the court's determination that the case is a single asset real estate case. The interest payments must be equal to the non-default contract interest rate on the value of the creditor's interest in the real estate. 11 U.S.C. § 362(d)(3).

Bolding mine. This provision poses an obvious problem for non-monetary and maturity defaults – the borrower has been willing all along to pay you the interest payments. In fact, their plan will be to pay you your full contractual interest payments for a period they project will be required for the market to recover. That is a very confirmable plan, and as long as the borrower performs under it, no foreclosure.

So why do lenders put nonmonetary default provisions in their documents? In theory, they allow a lender to take action in a deteriorating situation before there is an actual monetary default. That works fine in a stable or rising market, because the threat of a foreclosure might motivate the borrower to sell or refinance. However, it doesn’t work well when the borrower has no exit.

The best use of non-monetary default provisions is to trigger an event other than foreclosure which enhances your security (for example, unauthorized liens often cause a non-recourse loan to become recourse). That might get you somewhere. Foreclosing on a matured loan or a non-monetary default rarely works out favorably for the lender in a declining market.