Mark P. wrote to me to say that he’s interested in investing in non-performing notes – but what happens when the borrower files bankruptcy?
If you’re investing in non-performing notes this is something you need to keep in mind and it’s always a potentiality.
In this article we will explore the most common bankruptcy procedures and teach you how you can still make money off your investments even if your borrower files bankruptcy.
You will learn:
What is a Bankruptcy Reorganization
Accoring to nolo.com, the web’s largest library of consumer-friendly legal information:
Ordinarily, the debtor has the exclusive right for four months after it files Chapter 11 to propose a reorganization plan. Upon a showing of good cause, the court can extend the debtor’s “exclusivity period” to file a Chapter 11 plan to up 18 months after the petition date. The court also can shorten the exclusivity period depending on the circumstances.
A Chapter 11 plan allows a debtor to reorganize, or in other words, restructure, its financial affairs. A Chapter 11 plan is, in effect, a contract between the debtor and its creditors as to how it will operate and pay its obligations in the future. Most plans provide for at least some downsizing of the debtor’s operations to reduce expenses and free up assets. In some cases, “liquidating plans” are proposed to provide for a total shutdown of the debtor’s operations and the orderly sale of its remaining property.
Chapter 11 Bankruptcy: An Overview
A bankruptcy plan lays out a payback and/or liquidation schedule for a debtor.
How long does it usually take
When a debtor files bankruptcy the effect is immediate. No collection proceedings can continue for any of the debtor’s lenders until further notice.
Bankruptcies can vary in length depending on the type of bankruptcy, the region where its filed, and the complexity of the case and plan.
A Chapter 7 can be completed in as little as 3-4 months. I’ve personally been involved in CH11 cases that took well more than a year.
There is no absolute limit on the duration of a Chapter 11 case. Some Chapter 11 cases wrap up within a few months. Usually, however, it takes at six months to two years for a Chapter 11 case to come to a close.
If you would like to get a more indepth look into Chapter 11 bankruptcies and the legal statues surrounding it go to Chapter 11 Bankruptcy: An Overview.
Can I still Make a Profit
Yes! It is not uncommon for real estate lenders (which is what you are as a real estate note owner) to come out of a debtor bankruptcy “whole” meaning that they get 100% of the unpaid principal balance as well as, if available and agreed upon by the court, default interest and other penalties.
The only challenge here is, especially with commercial, you need to be liquid enough to defend your position and continue to run your business during the proceedings.
The Difference Between Commercial Debt and Homeowners.
Let me say first that the vast majority of my personal experience in this business is with commercial debt not with homeowners and the processes are different. However I’ve been in the business long enough that I’ll try to shed some light on both.
A bankruptcy filing creates a kind of a “time out”. So if you’re taking action on foreclosing on or collecting from a borrower then the bankruptcy filing will halt that activity.
In the case of commercial real estate this typically means the borrower has filed a chapter 11. The court will issue a “stay of execution” which is the order that causes you to halt. What the process usually looks like after that is that you’ll seek “relief from stay”. In order to be granted “relief from stay” you need to demonstrate to the court why the asset you’re foreclosing on shouldn’t be included in the bankruptcy but more importantly the borrower needs to show a workable reorganization plan.
I’m not an attorney and none of this is a qualified legal opinion or legal advice. It would be your attorney’s job to fight for your rights as the lender.
Depending on the bankruptcy district you’re in the length of this process will vary. I’ve seen relief granted in under 60 days and I’ve seen lenders denied relief and the borrower allowed a time period in which to execute their plan. A successful plan will typically result in your loan being repaid (from what I’ve seen).
Rarely have I seen these plans work, it is often a stall, but I have seen a few. The decision for the court will typically hinge on what kind of equity is or isn’t in the property for the owner.
First, understand what a homeowner’s rights are because as the owner of the note you’ll be on the other end of this. When you’re talking about homeowners things work differently than they do with commercial loans. The homeowner may try to exclude their residence from the bankruptcy file a Chapter 13 and keep the home or they could use the filing as an opportunity for a clean slate – Chapter 7.
In the case of a clean slate you’re going to have to wait for the filing to make its way through the court. At the end you’ll have the right to proceed. The benefit to the homeowner in addition the extended time in the home while they figure out their next move is if they’re in a state that would have allowed you to collect on the deficiency that right goes away.
In the case of a Chapter 13 the borrower is going to reaffirm the debt and continue to make payments.
When your borrower files bankruptcy there’s a “time out”.
As the lender you will seek to end the time out with your attorney. In the end most of the time you will end up foreclosing on the property but you will not be able to pursue deficiencies.
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