Can Lenders Still Foreclose When Borrowers File for Bankruptcy?
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It is not uncommon for a borrower to file for bankruptcy before or during a foreclosure lawsuit, or most commonly, upon the eve of the foreclosure sale. When a borrower files a voluntary petition under the Bankruptcy Code, Section 362(a) of the Bankruptcy Code provides an automatic stay of most actions against the debtor’s property, which prohibits lenders from commencing or continuing a foreclosure lawsuit. Lenders oftentimes make the mistake of sitting-back and waiting for the bankruptcy discharge before commencing or continuing their foreclosure lawsuit, instead of actively pursuing their rights in the bankruptcy proceedings. A better practice is for the lender to actively participate in the bankruptcy, to preserve and enforce its rights.
What are a Lender’s Options When a Borrower Files for Bankruptcy?
When a borrower files for bankruptcy, mortgage lenders have two primary options: (1) seek relief from the automatic stay in the bankruptcy proceedings; or (2) ensure adequate protection of its interest, including periodic payments, in the bankruptcy proceedings. Lenders may also challenge dischargeability of its unsecured debt (most commonly if the debtor committed fraud), or object to a Chapter 11 or Chapter 13 plan if the lender is not treated fairly.
Seeking relief from the stay will allow the lender to continue or commence the foreclosure lawsuit. However, if the value of its collateral exceeds the debt, the lender may not be able to seek relief from the automatic stay. In this case, it may be best for the lender to seek adequate protection.
Additionally, the lender’s best course of action may depend on the type of bankruptcy. Upon receipt of the notice of bankruptcy, lenders should first determine what type of bankruptcy the borrower filed in the bankruptcy court. Typically, the borrower will file for either a Chapter 7 (liquidation), Chapter 11 (reorganization), or Chapter 13 (adjustment of debts of an individual).
A Chapter 7 bankruptcy can be filed by individuals, partnerships, and business entities. This type of bankruptcy results in the some or all of the borrower’s property being sold and used to pay off debt. With respect to the collateral, the borrower has three options: (1) surrender—give the collateral back to the creditor; (2) redeem—pay the debt in a lump-sum payment; or (3) reaffirm—enter into a reaffirmation agreement with the creditor to pay the debt. The borrower’s choice factors heavily in the lender’s decision on a course of action. While a Chapter 7 case might not always require participation by creditors, a secured lender would be wise to consider active participation (or monitoring of the case at a minimum).
For instance, if the borrower chooses to keep the collateral in a Chapter 7, the secured portion of a creditor’s lien may sail through unaffected by the bankruptcy. In other words, a lender’s mortgage lien will not be discharged by a borrower’s bankruptcy filing, to the extent it is secured by value in the collateral. The lender, however, will still have to wait for the bankruptcy discharge before commencing or proceeding with a foreclosure (which can occur as quickly as 3 to 5 months). As a result, lenders may choose to take no action in the bankruptcy proceedings and foreclose on the property after discharge. On the other hand, if the lender is in a rush to foreclose on the property, the lender may choose to seek relief from the automatic stay. Importantly, if the lender does not obtain stay relief, the lender would be prudent to monitor the bankruptcy case, and object to any motions to strip or cram down its lien.
A Chapter 11 bankruptcy can be filed by individuals, partnerships, and business entities; however, it is usually used only by business entities. A Chapter 11 bankruptcy is used to reorganize a business so that it may continue operating its business and make debt payments. If a borrower filed for bankruptcy under Chapter 11, lenders should immediately retain counsel and file a notice of appearance with the bankruptcy court. In a Chapter 11 case, the debtor seeks to confirm a plan of reorganization, which should include adequate payments to the secured lender during the plan. However, debtors often try to confirm plans that provide lenders less payment than they deserve. Consequently, lenders must monitor the case and object to any unfair treatment proposed by the debtor.
A lender’s failure to actively participate in a Chapter 11 bankruptcy may also result in a loss or reduction of its mortgage lien on the collateral property. Thus, upon notification of a Chapter 11 bankruptcy filing, it is important for lenders 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 lender’s rights.
A Chapter 13 bankruptcy can only be filed by individuals, and results in a court ordered repayment plan to pay creditors in a 3 to 5-year period. At the end of the repayment plan period, the borrower will receive a discharge of unsecured debt. Like a Chapter 11, if a borrower filed for bankruptcy under Chapter 13, lenders should immediately retain counsel and file a notice of appearance with the bankruptcy court. Similar to a Chapter 11, a Chapter 13 debtor seeks to confirm a plan that should provide adequate protection to the secured lender, but the debtor may try to provide the lender less than the lender deserves.
A lender’s failure to actively participate in the bankruptcy proceedings may result in a loss or reduction of their mortgage lien on the property. Thus, like a Chapter 11 bankruptcy, upon notification of a Chapter 13 bankruptcy filing, it is important for lenders 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 lender’s rights.
The take-away for mortgage lenders is that if the borrower files for bankruptcy, lenders should take action in the bankruptcy court to protect their interest in the property. Lenders oftentimes make the mistake of sitting-back and waiting for the borrower to be discharged in the bankruptcy. If a mortgage lender receives notification that a borrower has filed for bankruptcy, lenders should retain counsel, seek relief from the automatic stay or seek adequate protection in the bankruptcy action, and evaluate other options that may maximize the lenders recovery.