As a long-time practicing attorney who specializes in representing private mortgage lenders in bankruptcy, I have frequently fielded common questions about various actions related to bankruptcy filings. This article will cover a few of those questions.

Can I Make a Refinance Loan to a Debtor in Bankruptcy?

On occasion, I get asked by a CMA member if it is okay to give a refinance loan to a borrower who is a debtor in an existing
bankruptcy. My response is: Assuming you follow your underwriting standards for making the loan, comply with state law disclosures, and obtain certain bankruptcy protections as a condition of your loan, you can make a refinance loan to a debtor in
bankruptcy.

What bankruptcy protections are necessary, you ask? First, you need a court order from the Bankruptcy Court that allows the debtor to obtain post-petition financing. That requires a debtor to make a motion to incur new debt or borrow money with
notice to creditors in the bankruptcy. Not all of the terms of the new loan need to be spelled out in the motion, but general approval of a loan not to exceed a certain amount and not to exceed a certain interest rate will be required. Second, if you are
going to be the new lender, you should ask for the motion and Order to include certain conditions of your loan.

One of those loan conditions is that the debtor stipulates to relief from stay in the event the debtor defaults on your loan. Not only should that be a condition of your agreement to underwrite the loan, but it should be in the motion and the Order approving the refinancing.

If you do not have any language in the Order regarding termination of the stay, and the Debtor defaults on your loan, you will have to make a motion for relief from stay to allow you to foreclose on the collateral and also to obtain possession if the collateral is the debtor’s residence. This is an increased cost that would not be necessary with prior approval in the order that provides for relief from stay to allow foreclosure and obtain possession of the property.

Another issue in the motion and Order is the allowance for you and/or your agents to send notices out directly to the debtor for monthly statements, default notices, etc. Without that specific provision in the motion and Order, you leave open the possibility of a defaulting debtor later seeking monetary sanctions against you for violation of the bankruptcy stay for sending those notices. A violation of the stay claim permits recovery for actual damages, attorney fees, and occasionally punitive damages. You can eliminate that risk by distinct language in the motion and Order regarding service of notices on a debtor.

Occasionally, a debtor will seek dismissal of its bankruptcy in contemplation of a new loan instead of seeking approval in the bankruptcy. If you are going to be that new lender, you must be careful not to make any promises of a new loan in exchange for a dismissal of the bankruptcy. You should not participate in that decision. If the bankruptcy is dismissed and your new loan is not completed and the current lender forecloses, the borrower is likely to concoct reasons to file suit against you.

It is always best practice to consult with your bankruptcy attorney when you are providing a refinance loan to a debtor in bankruptcy. The attorney can make sure the conditions of your loan are in the motion and Order and monitor the bankruptcy motion to address any questions from the judge.

What Happens to the Rents, Issues, and Profits of Income Property When a Bankruptcy is Filed?

Under California law, your deed of trust language usually provides a covenant that the rents, issues, and profits of the property are additional security for your loan (generally called an “assignment of rents” clause). The assignment of rents may also be in a separate loan document recorded contemporaneously with the deed of trust.

That assignment of rents clause is an absolute assignment of the existing and future rents under Civil Code § 2938. The language usually allows the trustor to collect the rents, issue, and profits while the loan is current. When the loan becomes delinquent, the lender’s right to collect the rents, issues, and profits, is absolute as additional collateral of your loan in addition to your security in the real property.

Most of the time lenders are dealing with rental income from either residential or commercial tenants. So, that will be the focus of this section.

If your loan becomes delinquent prebankruptcy, you have the right to try and collect the rents directly from the tenant after service of written notice to the tenant and to the borrower/trustor. Civil Code § 2938 sets forth the method and required language in the notice.

However, if the borrower/trustor or the tenant do not cooperate and turn over the rents, you need to have a receiver appointed to manage the property, make sure it is insured, and collect the income from the property. The timing for obtaining a receiver is important because the foreclosure process moves quickly. A sale can occur approximately four months from the time the NOD is recorded. You want to collect the rental income and prevent the borrower/trustor from collecting the rents for at least three of those months if possible.

Sometimes the receiver is just about to be appointed and the debtor files bankruptcy. Other times, the receiver is in place for a
few months and bankruptcy is filed just before sale. The treatment of the receiver in bankruptcy may be affected by the amount of time the receiver has been in place.

Under the Bankruptcy Code, the income from real property is defined as “cash collateral.” 11 U.S.C. § 363(a) provides: “… ’cash collateral’ … includes the proceeds, … rents, or profits of property….” Cash collateral also includes income from use or occupancy of rooms in hotels or other lodging facilities.

When a borrower files bankruptcy and owns income property, the first thing a lender should do (through its bankruptcy counsel) is to file and serve a pleading called “Notice of Perfection of Assignment of Rents” with the court. That provides all parties to the bankruptcy with notice that you hold an interest in certain cash collateral on a particular property and perfects your rights to the cash collateral. Additionally, there is case law that requires a creditor to make a claim for the cash collateral or that rental income belongs to the debtor until the creditor makes its claim by filing a notice.

Second, make sure your bankruptcy counsel contacts the debtor’s counsel in writing and puts them on notice that you do not consent to the use of cash collateral by the debtor. Ask the debtor’s counsel to provide a budget to you of necessary hold-back expenses (insurance, possibly pro-rata property taxes, and a small reserve for repairs) and agree to turn over the net cash collateral to you as lender on a monthly basis. Bankruptcy Courts prefer cash collateral agreements being negotiated by the parties so the Court does not have to decide issues related to a budget or turnover. Many Courts have special language and forms they require in determining cash collateral agreements.

If the debtor’s counsel and the debtor do not cooperate, then you will have to make a motion to prohibit the use of cash collateral and to sequester the rents. In my experience, a competent debtor counsel will prefer to negotiate the terms of cash collateral usage rather than fight a motion to prohibit its use.

If a receiver had been appointed prepetition, the Bankruptcy Code provides that the receiver is now a “custodian” and prohibits the receiver from distributing the debtor’s rents from the property, except as necessary to preserve the property. 11 U.S.C. § 543.

That same section requires the receiver, now custodian, to account and turnover the rents collected back to the debtor unless the creditor who had the receiver appointed can provide evidence to the bankruptcy court that the turnover provisions should be excused.

In order to keep the custodian in place and excuse the required turnover back to the debtor, the creditor must make a motion and seek to keep the receiver/custodian in place. One of the factors the court may consider is how long the receiver was in place before the bankruptcy was filed. If the receiver had been place for at least three months, the court may continue to keep the receiver/custodian in place for the protection of the lender creditor and other creditors in the bankruptcy. On the other hand, if the receiver was appointed just prior to the bankruptcy, the court is likely to remove the receiver/custodian and give possession of the real property and rents back to the debtor. Among other factors the bankruptcy court may consider are the pre-petition conduct of the debtor and the pre-petition condition of the real property prior to the receiver’s appointment. Whether to keep a receiver in place as custodian is going to be determined on a case-by-case basis. However, even if the receiver is removed, you have the
protections of limiting the use of cash collateral by the debtor as set forth above.

Conclusion

The takeaway for this article is for lenders to pay attention when their borrowers file bankruptcy. Retain competent bankruptcy counsel quickly to make sure your interests are protected. Do not ignore the bankruptcy filing at the outset because there are strict deadlines for filing claims, filing objections, and other issues that must be dealt with related to rental income and the stay.

Additionally, do not be afraid to make a loan to a debtor in bankruptcy if you follow all your underwriting guidelines and the conditions of your loan are incorporated into the motion to approve the refinance and resulting order.