Bankruptcy and its Effects on Foreclosure Proceedings

Q: How does the borrower filing bankruptcy change my commercial foreclosure filing?

A: The filing of bankruptcy by a mortgagor has become a common response to a foreclosure proceeding. The mortgagor may file a voluntary petition under the Bankruptcy Code and become a debtor under Chapter 7 (liquidation), Chapter 11 (reorganization), or Chapter 13 (adjustment of debts of an individual). One of the most important and usually immediate features of a bankruptcy filing is the automatic stay. Section 362(a) of the Bankruptcy Code provides an automatic stay of most actions against the debtor’s property, including actions to realize the value of collateral securing the obligations of the borrower. Under any chapter of the Bankruptcy Code, the main concerns of the mortgagee are the same: a) the mortgagee needs relief from the automatic stay imposed by the Bankruptcy Code so that the mortgagee can complete the foreclosure proceeding, or b) the mortgagee needs to ensure adequate protection of the mortgagee’s interest, including payments when appropriate, and property treatment of any plan of reorganization the debtor may devise under Chapter 11, 12, or 13.

Q: What is an automatic stay and how does it affect pursuing loan foreclosures?

A: Upon the filing of a Bankruptcy petition, the debtor receives immediate protection from the collection efforts of creditors through a §362 automatic stay. The automatic stay is one of the most fundamental elements of the bankruptcy code and acts to ensure an orderly distribution procedure that is otherwise hindered by the creditors’ conventional race to the assets. The Bankruptcy Code provides for stiff penalties to be assessed against creditors who knowingly violate the stay. The automatic stay is triggered by the filing of the bankruptcy petition and the petition date is definitive regarding the commencement of this protection. §362(a) defines the scope of the automatic stay by listing all of the acts and actions that are stayed by the filing the petition. A bankruptcy petition filed at any time up until the actual moment of the foreclosure sale acts to automatically stay the foreclosure proceeding. Relief from the stay is needed to commence or continue any proceeding to divest the debtor’s estate of property. This basically includes all acts of a foreclosure proceeding from the filing of the complaint through the sale of the property. The stay will continue until it is lifted, modified, or expires on its own accord.

Q: Once a bankruptcy is filed by the mortgagee, what are the basic steps for a lender in pursuing the mortgaged collateral or obtaining recovery of the loan?

A: Upon receipt of the notice of bankruptcy, the mortgagee’s counsel should immediately file a notice of appearance with the bankruptcy court. For the mortgagee confronting a stay prior to judicial sale, at least three avenues are present for possible relief.

At the forefront of options for extricating the mortgaged property from the bankruptcy is seeking relief from the automatic stay through moving the bankruptcy court. In most foreclosure scenarios, the primary ground for seeking relief from the automatic stay is the contention that the property enjoys no significant equity value above the mortgaged debt that can benefit the estate. Bankruptcy courts allow a secured creditor to lift the stay for “cause.” Establishing “cause” might include showing that the property enjoys no significant value over the mortgage debt (i.e. the debtor has no equity in the property) and that the property is not needed for a reorganization. The rationale behind lifting the stay in such a scenario is that, in the absence of an “equity cushion,” nothing of value remains in the property for the unsecured creditor. “Cause” might also include showing that the creditor’s interest in the property is not adequately protected such as if the property was uninsured. In a Chapter 7 case the court’s focus is generally on whether or not there is any equity in the property for the benefit of the debtor.

The second strategy a mortgagee could employ involves making a request for “adequate protection.” Even if a creditor is denied relief the automatic stay, the bankruptcy court may provide “adequate protection” in the form of requiring debtor to make periodic cash payments to the creditor. The philosophy is to compensate the creditor for a decline in the collateral; the amount by which the collateral depreciates is the amount of adequate protection to which the secured creditor is entitled. Commonly, bankruptcy courts will maintain the automatic stay (with the foreclosure frozen in its tracks) so long as adequate protection payments are made. But if a bankruptcy debtor fails to make these payments, the stay may be lifted. Adequate protection can also include requirement that the debtor make payments for insurance, taxes and other related expenses of the property.

The avenue a mortgagee could adopt is to challenge the entire bankruptcy filing on the basis that the filing is predicated on bad faith. Bad faith exists where it can be proven that the debtor has no realistic prospect for reorganizing and seeks merely to frustrate the secured creditor’s entitlement to realize upon its collateral. Bad faith can exist where a debtor has equity in the property such as in single asset cases where the business has no operations or other significant creditors, and the debtor’s asset consists of non-income producing property. Also, unreasonable delay in moving through a bankruptcy filing can also constitute bad faith dismissal. Even if bad faith dismissal is not granted, evidence of bad faith may cause court to lift automatic stay. This is often a final fallback position in the event the mortgagee is denied adequate protection.

Failure to obtain relief from the stay is not always a bad thing, for it often means that there is collateral in the property that the trustee can use to satisfy the creditors in order of priority. As a secured creditor, a mortgagor often will have all principal, interest and default fees satisfied from this liquidation.

Bankruptcy issues with secured creditors can often be very complex and it is recommended that counsel be engaged to deal with these issues in order to adequately protect the creditor’s rights and the protection of collateral.