Chapter 13 | Distressed Real Estate Loan and Bankruptcy Basics

Overview

This chapter focuses on what can happen when a borrower defaults on a senior mortgage loan.  One distressed loan resolution option is bankruptcy.  Senior lenders have contractual rights to cash flows and collateral throughout the life of a loan.  Lenders also may have the right to foreclose on a property if the borrower violates the terms of the loan agreement.  In foreclosure, a lender with a first security position can theoretically take control of the property and sell it through an auction.  In such a situation, the borrower may be responsible for capital gains taxes resulting from the foreclosure or bankruptcy process.

Summary

Distressed loans can be resolved through restructuring, dissolution, or through the borrower filing for bankruptcy protection.  Bankruptcy laws in the U.S. afford borrowers certain rights.  Additionally, bankruptcy law trumps contract law.  There are two basic types of bankruptcies in the US: Chapter 7 and Chapter 11.  In a Chapter 7 bankruptcy, the debtor ceases all operations, goes completely out of business, and a trustee is appointed to sell the property and other assets in an attempt to pay off obligations through this liquidation.  In a Chapter 11 bankruptcy, the process attempts to conserve going-concern value, generally requiring a consensual plan of reorganization.  Chapter 11 bankruptcy law permits a borrower to prevent a lender from immediately seizing an asset.

U.S. bankruptcy law allows for debtor in possession financing.  This allows the defaulting party to subordinate existing debt claims to new debt, which is taken on to operate the business as it attempts to emerge from bankruptcy.  Additionally under Chapter 11, borrowers do not have to pay interest, can choose not to pay rent, cannot be immediately evicted, may break leases, and may sublet space.  The bankruptcy court’s job is to supervise the attempt to maximize the value of all assets.

The absolute priority rule states that no junior creditor will receive consideration until all senior creditors are paid in full, and no equity holder will receive consideration until all creditors have been paid in full (including interest).  The new value exception to the absolute priority rule allows a debtor to contribute fresh capital in exchange for the ownership of the property as it exits bankruptcy.  The Bank of America vs. La Salle Street Partners case requires the new equity position to be offered to the market and not simply to the original owner.

In Chapter 11, both recourse and non-recourse lenders are permitted to file an unsecured deficiency claim when the value of the property is not sufficient to cover the entirety of creditors’ outstanding debt.  Under section 11.11B, the lender can waive a deficiency claim.  A lender would only waive a deficiency claim if they believe that the debtor will fail again, in which case the lender would retain the larger secured claim.  If the lender accepted the deficiency claim and the property subsequently defaulted, the lender would only have the secured claim.  This option is available only during Chapter 11 protection.

As a borrower, one can use bankruptcy both offensively and defensively, so be sure to understand one’s rights and restrictions under bankruptcy laws before taking out a loan.

Questions

These are the types of questions you’ll be able to answer after studying the full chapter.

1. Please explain how Chapter 7 and Chapter 11 bankruptcies differ in the U.S.

2. Please explain why an owner who is foreclosed upon would have to pay capital gains taxes.

3. Why would a lender waive a deficiency claim?

Key Terms

To view the definition, click or press on the term. Repeat to hide the definition.

When the agreed upon debt service payments have ceased being made when they are due.

Making all missed payments to bring the loan payments current.

When the borrower fails to cure their delinquency.

Changing the terms of an outstanding loan so that it can once again be current and ultimately be repaid. The interest rate and/or amortization term can be modified to reduce the monthly debt service payment to make it affordable to the borrower; can be done temporarily or undone once the ability to pay in full (per the original terms) has been restored.

A property sale whose proceeds are not sufficient to pay back the full amount owed on the mortgage.

Real property that sits on the liability side of a lender’s balance sheet after the lender forecloses on the defaulted borrower.

A investor that buys distressed mortgage notes from lenders at discounts to the unpaid principal balances.

Legal protection for borrowers from their creditors; bankruptcy law provides a structured mechanism by which debtors unable to meet the terms of their credit agreements can attempt to resolve their debts and other liabilities.

When a lender with a first security position takes control of the property from a defaulted borrower.

Those with positions subordinate to the senior debt.

The debtor creases all operations, goes completely out of business, and a trustee is appointed to sell the property and other assets in order to pay off obligations with sale proceeds.

Created in 1978 to formalize the business reorganization framework. Codified the view that reorganization of the business is generally preferred to liquidation.

Allows the defaulting borrower to subordinate existing debt claims to new debt which is taken on to operate the business while it attempts a successful reorganization.

No junior creditor will receive consideration until all senior creditors are paid in full, and no equity holder will receive consideration until all creditors have been paid in full (including interest).

The debtor proposed contributing fresh capital in exchange for the 100% ownership of the property as it exited bankruptcy.

The value of the property is not sufficient to repay the entirety of the creditors’ outstanding debt.

Debt not backed up by an underlying asset.

The imposition of a bankruptcy reorganization plan by a court despite any objections by certain classes of creditors.

Mortgages for which the creditor can only look to the property to recoup owed principal and interest.

The difference between the loan value and the collateral value is the deficiency claim against the borrower which becomes part of the unsecured claims pool.

Chapter Headings

  • Distressed Loan Resolution Options
  • Loan Restructuring
  • Dissolution Options
  • Bankruptcy
  • Borrowers’ Rights
  • Bank of America Versus La Salle Street Partners
  • Section 11.11B

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