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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2014

Bankruptcy and Receivership Basics

Two common workout remedies offer aid in distressed-property recovery

Even though the economy is rebounding, distressed property remains an issue in the commercial real estate market. Mortgage professionals who are the most knowledgeable about ways to work around troubled assets will have a distinct advantage in this niche. Bankruptcy and receivership are two powerful workout strategies for recovering distressed assets that can reap lucrative and efficient results for those who understand their uses and the differences between them.

Confusion between bankruptcy and receivership is common, but they are actually quite different. In a nutshell: Bankruptcy courts are focused on protecting the borrower, and a bankruptcy is typically filed to protect a borrower/debtor from collection actions by creditors. In contrast, a receivership is filed during a foreclosure proceeding to protect the asset by having an independent third party take possession.

Beyond these basic differences, bankruptcies and receiverships diverge even further in ways that mortgage professionals should understand.

Bankruptcy

The two most common types of bankruptcy in the commercial lending context are Chapter 7 and Chapter 11 of the U.S. Bankruptcy Code.

A Chapter 7 bankruptcy seeks to protect a debtor from creditors via the liquidation of nonexempt assets through the appointment of a trustee. The trustee sells all the assets that are subject to the bankruptcy and disburses the proceeds to the creditors in accordance with the schedule of claims, which creates a prioritization of how creditors are to be recompensed.

Similarly, a Chapter 11 bankruptcy seeks to protect the debtor’s interest, but in this case by allowing the debtor to restructure assets and refinance to cure indebtedness. It is not uncommon to appoint a trustee to oversee and carry out the reorganization of assets in a Chapter 11 bankruptcy, but using a “debtor in possession” to implement the reorganization is the more common practice. This allows the debtor a substantial amount of time to craft and present a reorganization plan to the court. The plan typically mandates that the creditors accept a fraction of the amount they are owed.

“For commercial lenders, the best strategy when approaching bankruptcy is planning. Developing an early strategy to navigate the bankruptcy process allows for implementation of key negotiation tactics.”

Conversely, the plan may require the creditors to accept repayment of the amounts owed over an extended period of time, although the amounts may be calculated solely on the basis of the value of the lender’s collateral, not the total amount of the lender’s claim.

The court may approve the reorganization plan if it determines it is fair and equitable, so it is important for the lender to keep an open line of communication with the debtor to ensure that an amicable plan is provided to the court for approval.

Exit strategy

For commercial lenders, the best strategy when approaching bankruptcy is planning. Developing an early strategy to navigate the bankruptcy process allows for implementation of key negotiation tactics.

More specifically, that means creating and tailoring a plan that will yield the most recovery and will limit litigation by using the rules of the bankruptcy code to the lender’s advantage.

Automatic stay

A key component and strategic benefit of bankruptcy is detailed under Section 362 of the Bankruptcy Code, otherwise known as the automatic stay provision. An automatic stay is immediately implemented once a bankruptcy petition is filed and acts as an injunction that effectively stays the continuance of creditor actions against the debtor or debtor’s assets. The automatic stay protects the debtor from pending creditor actions and prevents creditors from filing additional lawsuits against the debtor during the term of the automatic stay.

An automatic stay is neither permanent nor absolute — it remains active until the judge lifts the stay or the bankruptcy is discharged. Obtaining relief from a stay for secured lenders is and should be a priority, although relief does not grant control of the property and/or assets back to the debtor or to the lender. Instead, it affords the lender the opportunity to pursue its foreclosure remedy at the state-court level.

Restrictions

Before moving for a relief from stay, lenders should consider the restrictions — which act to protect the assets — that bankruptcy places on debtors. The cash collateral of a secured lender cannot be used by the debtor without the lender’s consent or an order from the court.

Lenders can and should take this opportunity early in the case to negotiate favorable terms with a debtor, allowing them use of the cash collateral in return for wanted concessions. This agreement between debtor and creditor will outline a budget and allow for certain expenses to maintain operations, as well as protect the value of the collateral.

Section 363 sales

Another means of potential recovery in bankruptcy for a lender is detailed under Section 363 of the Bankruptcy Code, more commonly referred to as a 363 sale. A 363 sale allows the bankruptcy court to authorize the sale of an asset, so long as it is in the best interest of the bankruptcy estate and its creditors.

In determining this, the court works to ensure that the highest and best offer has been accepted and that the terms and conditions of the sale were negotiated in the best interests of all the parties. When this standard is met, the court is able to approve the sale. In the event that the proceeds from the sale are not enough to recompense the secured creditor(s) in the matter, then the secured creditor has the right to object to the sale. In this instance, the sale cannot be approved.

Receivership

A receiver is an unbiased third party that is appointed by the court to oversee and protect an asset during the foreclosure process.

In contrast to bankruptcy, the practice of receivership and the laws that govern it are typically underutilized. This underutilization stems more from a lack of knowledge than from the effectiveness of this remedy. Although many types of receiverships exist, commercial lenders typically use the rents-and-profits type to secure and protect the secured assets, commonly real property, during foreclosure litigation.

To appoint a receiver, the court must determine whether or not the debtor will act in the best interests of the asset through the course of litigation. It is incumbent upon the lender to provide reasonable support evidencing the debtor’s malfeasance.

By design, receivership works to safeguard the lender’s secured interest in the debtor’s asset(s) during litigation. This safeguard also may be presented to the debtor in a positive light, as the receiver’s goal is to stabilize the asset and, with court approval, use any funds generated by it to pay down secured amounts owed by the debtor.

Presenting the proposed receivership to the debtor in this manner often results in the debtor being less litigious and more willing to enter into a stipulation for the appointment of a receiver, both of which help to save the lender time and legal costs.

Operating businesses

The intricacy of operating differing business types adds a level of complexity for which lenders may not be prepared. Although many lenders may have a strong understanding of real estate, they may not understand how, for example, a canning business works and where the value in that business lies.

As a result, requesting the appointment of an experienced receiver may be extremely helpful. Experience enables the receiver to address immediate issues related to payroll, employment liability, tax liability, managing vendor and supplier relationships, and communicating and obtaining the proper licensing, as well as a plethora of other tasks associated with operating a business. 

Receivership sales

As with bankruptcy, an asset can be sold through receivership with court approval, which benefits lenders because they do not have to take title to the property as they would if it was foreclosed upon.

A receivership sale is also more cost- and time-efficient than foreclosing on a property, as the receiver is able to conduct a sale fairly effortlessly upon the court’s approval. The alternative to a receivership sale would require a lender to complete the time-consuming process of foreclosure, taking title to the property, and overseeing marketing and sale efforts.

Overlap

Although bankruptcy and receivership are two distinctly different workout remedies, some overlap may occur. For example, in some instances a litigious debtor may file for bankruptcy while a receiver is in place to delay a foreclosure or receivership sale, or to undermine the lender’s efforts.

Although an automatic stay halts the foreclosure action, the lender has the ability to request that the receiver remain in place during the bankruptcy to preserve the assets. Furthermore, the lender also has the option to move for relief from the automatic stay. If the relief from stay is granted, the case reverts back to the state court.

• • •

Both bankruptcy and receivership will continue to play an important part in how the commercial real estate lending industry handles recovering distressed assets. Savvy mortgage-lending professionals should take the time to learn and understand the nuances of both of them to keep a professional edge in today’s ever-evolving marketplace.  •



 
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