Dealing with the Borrower’s Bankruptcy
Bankruptcy filings are an unfortunate fact of life. As interest rates rise and as legislative measures enacted to provide debt relief during the Covid pandemic expire, observers agree that rates of bankruptcy filings by both individuals and businesses are once again beginning to increase nationwide.
Secured lenders therefore need to be aware of the obstacles posed by their borrower’s bankruptcy petition, the most formidable being the “automatic stay” of section 362(a) of the Bankruptcy Code. This article is only an introduction to this obstacle, and is no substitute for careful analysis and counsel from a qualified legal professional.
Commencement of the Bankruptcy Case and the Automatic Stay.
The borrower commences a bankruptcy case (and thereafter becomes known in the case as “the debtor”) by filing a petition for relief in the Bankruptcy Court. The filing of the petition immediately creates, without further court proceedings, a stay (prohibition) of all actions against the debtor to collect debts, enforce monetary obligations, or foreclose on liens or deeds of trust against property in which the debtor has an interest. The stay is effective whether or not the creditor has notice of the bankruptcy filing. The bankruptcy filing also creates what is known as the “bankruptcy estate,” which is protected by the automatic stay and generally includes all of the debtor’s property and property rights.
The automatic stay is very broad, and the bankruptcy estate is very inclusive. Among other things, the stay prohibits creditors from bringing or going forward with proceedings against the debtor or the debtor’s property which were or could have been commenced before the bankruptcy filing. It prohibits the enforcement of judgments obtained before the bankruptcy filing, either against the debtor or the debtor’s property. And it prohibits acts to create, perfect, or enforce liens against property of the debtor or the debtor’s bankruptcy estate. Certain acts are excluded from the scope of the automatic stay, and certain property from the bankruptcy estate, but they are relatively few in number and are narrowly construed.
A creditor who proceeds against a debtor or the debtor’s property after a bankruptcy filing without first obtaining authority from the Bankruptcy Court to do so is typically taking a great risk. An act prohibited by the stay but unknowingly performed by the creditor will in some judicial circuits be considered, from the outset, void and without effect (not merely voidable, where a court need issue an order voiding the act). But knowing violations of the automatic stay can expose the creditor to liability for payment of actual damages including attorneys’ fees, and, in individual bankruptcy cases, punitive damages and a finding of contempt of the Bankruptcy Court’s authority.
The Bankruptcy Petition Has Been Filed: What Now?
A common scenario for a bankruptcy filing occurs where the petition is filed on the eve of a trustee’s sale or foreclosure of real property, where the trustee receives a phone call or email memo from the debtor’s attorney regarding the bankruptcy filing. At this point, the foreclosing creditor should exercise great caution and restraint.
First, the creditor should immediately cease all collection and foreclosure activity as to the debtor, even where notification of bankruptcy is merely oral. The creditor should promptly seek confirmation of the bankruptcy filing, by asking for and receiving from the debtor or attorney a copy of the bankruptcy petition or documentary evidence of the filing issued by the Bankruptcy Court. Such documentation should include the name(s), address(es), and a redacted social security or tax identification number(s) of the debtor(s), and a statement of the date of filing, the case number, and the court in which the petition was filed. The Bankruptcy Court issues a written Notice of Bankruptcy Case, with this and other information, but usually it is not available until days after the bankruptcy petition is filed (a copy is generally mailed to creditors who are identified by the debtor in papers filed with the court). If the foreclosure involves any bankruptcy debtor, or any property in which any debtor has an interest, the creditor should assume that the automatic stay applies. The stay and estate are considered by many courts to be broad enough to prevent foreclosure by a senior lien claimant against property in which the debtor holds a junior lien or similar interest.
Second, the creditor should understand that the automatic stay does not to prevent the secured creditor from merely postponing any pending foreclosure proceeding. For example, if the creditor had recorded a Notice of Default and was poised to conduct a trustee’s sale when the bankruptcy was filed, the creditor can, pursuant to state law, continue (i.e. notice to a later date) the sale (as opposed to cancelling the sale). Continuing the sale merely preserves the status quo, but so long as the bankruptcy case remains the creditor must refrain from doing anything whatever to go forward with foreclosure, until such time as the Bankruptcy Court may permit it.
On receiving notice of a bankruptcy, the creditor should quickly analyze whether the Bankruptcy Court is likely to provide relief from the automatic stay to permit the creditor to complete the foreclosure process. As an alternative, on request the court may also enter an order providing that the creditor must receive payments to protect the creditor’s interest in the property during the course of the bankruptcy case.
A detailed discussion of the various grounds for obtaining relief from the automatic stay to complete the foreclosure process or for compelling the debtor (or the bankruptcy trustee) to provide “adequate protection” payments during the course of the bankruptcy case is beyond the scope of this brief article. But the Bankruptcy Code does provide for such relief under particular circumstances. For example, the lack of an equity cushion to protect the creditor’s position, coupled with a lack of ongoing payments to the creditor, usually constitute grounds for relief from stay. Another common ground for relief exists where a debtor has filed the bankruptcy petition in bad faith, as part of a scheme to hinder creditors.
It is also important to consider that the automatic stay terminates when the bankruptcy case is closed or dismissed. It is not uncommon, particularly in the context of non-commercial loans, for a borrower to file a bankruptcy petition simply to gain more time, and to ask for or not oppose dismissal once the bankruptcy case stalls for lack of prosecution. A full discussion is beyond the scope of this article, but should such debtor file sequential petitions after a dismissal, the Bankruptcy Code includes provisions designed under certain circumstances to terminate or prevent the automatic stay from commencing in the most recently-filed case, without need for a request for relief by any creditor.
What Can a Lender do to be Prepared?
The most effective preparation for a lender is to keep complete and accurate records. Copies of all notes, recorded security documents, payment records, and property appraisals should be kept ready in the event a bankruptcy is filed, since such documentation is typically critical to requesting and obtaining relief from the automatic stay.
Obtaining an award for attorneys’ fees and costs is never a sure thing, and such an award available to the secured creditor only under certain conditions in any event. The lender can, however, benefit from specific language in the note, deed of trust, and related loan documents, to the effect that the borrower agrees to pay the lender’s attorneys’ fees and costs incurred by the lender due to the borrower’s bankruptcy, including but not limited to those related to monitoring the bankruptcy case and for obtaining relief in the Bankruptcy Court.
Some lenders include in loan documents a provision under which the borrower agrees not to contest a relief-from-stay motion should the borrower file for bankruptcy protection. While such a provision might be useful as part of a workout for a troubled loan, courts have not uniformly permitted enforcement of such provisions. Lenders should understand, too, that courts and authorities weigh heavily against the enforcement of such provisions in the consumer-loan context.
Points to Remember.
As noted above, this brief article cannot do more than just mention a few of the many issues which arise when the borrower files a bankruptcy petition, and it is not intended to provide legal advice in connection with any specific case. Overall, however, the secured creditor should be careful not to violate the automatic stay and should also realize that appropriate relief may be obtained with diligent effort and the right factual circumstances. Unfortunately, the creditor will be forced to exercise considerable patience, since relief never comes soon enough. But the process can be expedited by staying within the confines of the law and by providing any legal professional who becomes involved with all relevant documentary materials and a full explanation of the status of foreclosure efforts to date.
© 2022, Anthony Asebedo
Attorney at Law