Bankruptcy filings indicate a debtor’s lack of working capital and, justifiably so, strike concern into any lender still hanging on to a promise of payment from their debtor. But, depending on the creditor’s agreement with the debtor and the creditor’s actions after payment default, a creditor could recuperate collateral assets or a portion of the outstanding payments. This general overview helps lenders identify the challenges and opportunities they will encounter during each type of common bankruptcy filing.
Introduction to Bankruptcy for Lenders
Bankruptcy is governed by federal law, Title 11 of the United States Code. The various chapters of the Code outline the different types of bankruptcy:
- Chapter 7: Liquidation
- Chapter 9: Municipalities
- Chapter 11: Reorganizations
- Chapter 12: Family Farmers or Fishermen
- Chapter 13: Individuals
- Chapter 15: Cross-Border Cases
Chapters 7, 11, and 13 are most commonly used in bankruptcy proceedings. Id. Each chapter affects lenders differently because each chapter offers the bankruptcy-filing debtor different options.
Bankruptcy proceedings can commence in two ways: either (1) the debtor voluntarily petitions for bankruptcy or (2) the creditors file a petition forcing the debtor to involuntarily file for bankruptcy. Id. Involuntary petitions are not common, but can be maintained if the creditors meet the requirements enumerated in Bankruptcy Code Section 303. Westlaw, The Involuntary Bankruptcy Process, Practical Law Bankruptcy & Restructuring and Practical Law Finance, (last visited Mar. 21, 2020).
Regardless of how the bankruptcy proceedings start, the way creditors are compensated follows a generally consistent structure: secured creditors are paid first at the value of their collateral, followed by tiers of unsecured creditors paid from the remaining assets. Westlaw, Order of Distribution in Bankruptcy, Practical Law Bankruptcy & Restructuring and Practical Law Finance, (last visited Mar. 21, 2020). If there are multiple creditors in the same tier, then they are compensated on a pro rata basis. Id. However, there are differences between the payment rights of secured creditors depending on the bankruptcy chapter that governs the proceedings. Since most conventional loans have some sort of collateral attached to it, the focus of this article will skew towards assessing lender rights as a secured creditor. Irrespective of the type of filing, let one takeaway endure: if you are a lender and your debtor files for bankruptcy, you need to review the filings and monitor the proceedings in order to evaluate your risk.
As set forth below, almost all the time, a lender whose loan is secured by an in force, pre-bankruptcy lien will not be required to participate in the Chapter 7 bankruptcy proceedings in order to maintain collateral lien rights and enjoy secured creditor status. By setting up systems to monitor the proceedings and knowing what limited circumstances (i.e. affirmative action by the debtor or trustee) whereby a lien can be impaired, lenders are able to save themselves time and money in strategies for dealing with Chapter 7 filings. Knowing the value of your collateral in these circumstances is key, for the collateral is likely the only recovery the lender will get in Chapter 7’s.
There may be risks, however, to failing to participate in other types of bankruptcy cases. Chapter 11 and Chapter 13 filings invoke a different set of laws and procedures, almost all of which are designed to address complex, secured debt. Plain review of the code provision applying to Chapter 7 discharge, Bankruptcy Code Section 524, shows that different terms and requirements are imposed by Bankruptcy Code Sections 1141 and 1327 relating to Chapter 11 and Chapter 13 cases, respectively.
How Lenders are Affected by Different Bankruptcy Chapter Filings
Chapter 7 Bankruptcy Proceedings
Chapter 7 can be utilized by corporations, partnerships, brokers, and individuals. Westlaw, Bankruptcy: Overview. A debtor can only file under Chapter 7 if the debtor has little to no income and the debtor intends to liquidate all their assets. After a Chapter 7 petition is filed, creditors are automatically prevented from taking any action against the debtor to independently recover on their defaulted loans. Id. Additionally, a trustee is created to collect all the debtor’s assets and distribute them amongst the creditors according to their position of priority. Id. The debts of individuals are washed away by the Chapter 7 bankruptcy process. Some types of debts are prohibited from discharge, including taxes, child support obligations, and some forms of consumer debt. Id. If a corporation, partnership, or other legal entity has filed for Chapter 7 bankruptcy, the entity is dissolved at the end of the case. Id.
As a fundamental proposition dating back to the earliest bankruptcy precedents in our country, lenders with a security interest can enforce their lien against collateral after a Chapter 7 bankruptcy case or once the automatic stay is no longer in effect. This typically occurs through foreclosure or replevin lawsuits since the creditor’s lien stays with real property until foreclosure, despite debtor’s bankruptcy filing. Bankr.Code, 11 U.S.C.A. § 506(d). Dewsnup v. Timm, 502 U.S. 410 (1992). It would be a unique circumstance- one in which the creditor would surely be noticed by an aggressive debtor or trustee- for a lien to be extinguished or modified in a Chapter 7 bankruptcy case. Chapter 7 affected secured creditors may choose not to participate in bankruptcy process, not to file proof of claim, and to look solely to its lien for satisfaction, unless appropriate affirmative action is taken during the Chapter 7 case to avoid or “pay off” or other impairment of a security interest in collateral. See In re Wolf, 162 B.R. 98 (Bankr. D.N.J. 1993); In re Honaker, 4 B.R. 415 (Bankr. E.D. Mich. 1980).
As a result, creditors whose security is greater than the value of the debt have the option of taking no action in the Chapter 7 proceedings, other than action to pursue the collateral. Secured creditors can enforce their lien in the event of default by simply foreclosing on the collateral, receiving its value. Matter of Penrod, 50 F.3d 459, 461 (7th Cir. 1995). Naturally, creditors cannot pursue or collect on the personal liabilities of the debtor prior to bankruptcy, as set forth in Bankruptcy Code Section 524.
Chapter 11 Bankruptcy Proceedings
Chapter 11 filings can be utilized by corporations, partnerships, foreign companies, and individuals. Westlaw, Bankruptcy: Overview. Chapter 11 filings differ from Chapter 7 filings because Chapter 11 allows debtors to continue operating their businesses. Chapter 11 bankruptcy is not required to end in complete liquidation like Chapter 7 filings; rather, Chapter 11 filings operate to create a plan of repayment to lenders. Id. This plan must be approved in order to terminate the bankruptcy proceedings. Creditors and shareholders are divided into different voting classes. Id. A plan is approved if holders of two-thirds in amount and more than half the number of claims in each voting class vote to approve the plan. 11 U.S.C.A. § 1126(c) (1984).
Unlike Chapter 7 cases, secured creditors in Chapter 11 cases may lose their lien or collateral during the bankruptcy proceedings. Any lender whose borrower has filed a Chapter 11 should tightly monitor the proceedings and actively engage to advocate preservation of lien rights. There is an abundance of case law in bankruptcy proceedings that confirm that a secured creditor’s lien may be extinguished under a Chapter 11 plan if the lienholder fails to object to the treatment or lack of treatment under a confirmed plan. If the lender actively participates in the Chapter 11 proceedings (i.e. filing a proof of claim, motion practice, etc..), it is held to higher standards upon review by courts as to whether a debtor disputed lien would survive a Chapter 11 filing if the secured creditor did not resolve the issue. Therefore, it is best practice to engage counsel to review the filings, evaluate the strength of the lien position and assess appropriate actions to take in order to preserve the rights of every lender in Chapter 11 proceedings.
Chapter 13 Bankruptcy Proceedings
Unlike Chapter 7 and Chapter 11 cases, Chapter 13 cases are always voluntary. Westlaw, Bankruptcy: Overview. Chapter 13 filings are reserved for only individual debtors, not corporations or partnerships. Id. Chapter 13 filings are similar to Chapter 11 filings in that they allow the debtor to create a payment plan that does not require complete liquidation of all assets. To utilize Chapter 13, the debtor must be one with a “regular income” and one owing no more than $419,275 in unsecured debts and $1,257,850 in secured debts. Id. This form of bankruptcy will allow creditors to stake a claim on post-petition earnings of the debtor for a period of three (3) to five (5) years (e.g. wage garnishment). Id.
Secured creditors engaging in Chapter 13 cases may find themselves in a different position than they do in Chapter 11 cases. Typically, if a Chapter 13 plan is confirmed without providing for a secured creditor’s lien, the lien will still pass through the bankruptcy and remain intact like filings in Chapter 7 and Chapter 11 cases. However, Section 1327(c), which applies to Chapter 13 cases, states that: “Except as otherwise provided in the plan or in the order confirming the plan, the property vesting in the debtor…is free and clear of any claim or interest of any creditor provided for by the plan” has different language than Section 1141(c), which applies to Chapter 11 cases. This difference in language has caused dissimilar outcomes for secured creditors looking to protect lien rights in Chapter 13 cases versus Chapter 11 cases, and should be reason enough for lenders to review Chapter 13 filings with caution in order to determine whether lien rights are “provided for” or otherwise preserved.
Secured creditors cannot fall asleep at the wheel during Chapter 13 proceedings. If a Chapter 13 plan undervalues a creditor’s lien and the creditor does not object before the plan is confirmed, then the confirmed plan will limit the creditor to recovering on the lien for no more than that confirmed value. See e.g. In re Rodnok, 197 (Bankr. E.D. Va. 1996), and In re Pence, 905 F.2d 1107 (7th Cir. 1990).
How to Protect Lender Interests During Bankruptcy
By their very nature, secured interests are extremely valuable. Though Chapter 7 bankruptcy cases allow collateral liens to remain on the property through the bankruptcy proceedings, lenders should be mindful that the lien and claim may still be attacked. Chapter 11 and 13 filings provide unique challenges (read: unique opportunities also) to secured lenders to participate in the debtor’s case and negotiate the treatment of claims from a position of relative strength. Failing to engage in restructuring proceedings can be a costly mistake for a lender, with the most consequential risk being the loss of any recovery, including lien rights.
Lenders need to be careful during bankruptcy proceedings to ensure these interests remain intact after a filing. As a lender, you should contact qualified and experienced legal counsel before taking (or not taking) actions during bankruptcy proceedings which may affect your rights.