Although we’ve yet to see a wave of U.S. bankruptcies emerge from the 2020 re-cession, expect more filings in the coming years. The COVID-19 pandemic forced many businesses to shutter, drying up income for debt-laden restaurateurs, hotel operators and retailers. Companies that were overextended prior to the pandemic may be pushed into bankruptcy.
When a company files for bankruptcy, the business usually turns its property over to a trustee appointed by the bankruptcy court. In some cases, the owner can exempt certain property from the proceeding. In many other situations, however, buildings and land will eventually be sold with the debtor’s other assets to pay creditors and lien holders.
This can lead to increased business opportunities for commercial mortgage brokers who work with investors in distressed real estate. Bankruptcy filings, however, also can affect the timetable of a distressed sale by delaying a foreclosure proceeding.
People often confuse a bankruptcy with a foreclosure, but these proceedings have much different purposes. Bankruptcy filings are made in U.S. Bankruptcy Court under a uniform set of procedures defined by federal code. In contrast, foreclosures are typically handled at the county level and the process varies by state.
In a foreclosure, a lender is seeking to recoup the loan balance owed on the asset. In a bankruptcy, an individual or business is attempting to gain relief from creditors. In some cases, a bankruptcy enables a company to stay in business and keep its property while it reorganizes. When an owner files for bankruptcy, the court will typically suspend any foreclosure proceeding, pending a decision. It is worth reviewing the two major bankruptcy options open to businesses, as the end game often differs and this can affect the real estate.
Bankruptcies can get complicated when real estate is involved.
Chapter 7 bankruptcy
A business can file for Chapter 7 bankruptcy when its debts are too large to restructure. This also is referred to as a liquidation bankruptcy. Corporations, sole proprietorships or partnerships can file under this bankruptcy chapter.
Businesses must take a means test to see if they are eligible for Chapter 7. To qualify, the business’s income must be below a certain level. The company is dissolved once the Chapter 7 bankruptcy is approved. Chapter 7 tends to be the quickest form of bankruptcy, taking about three to six months.
When a company files for Chapter 7 bankruptcy, the court appoints a trustee to liquidate the debtor’s assets and repay creditors as much as feasible. Typically, the trustee rejects leases and contracts because they are of no value to creditors or because the contract restricts the transfer of interest. If the trustee assumes a lease, they can either sell it for a profit or assign it for a lump-sum payment to a creditor. This, however, is an extremely rare occurrence.
Usually, businesses opt for this chapter when there are no substantial assets. A court-appointed trustee takes possession of the business’s assets and distributes them among the creditors. After the asset distribution and trustee payment, a sole proprietor receives a discharge from their debts, but corporations and partnerships are not discharged. The business is closed, assets are liquidated, and the proceeds are distributed to pay the creditors. The trustee can even pursue the partners and go after their bank accounts or home equity to repay creditors.
Chapter 11 bankruptcy
A Chapter 11 bankruptcy is a better option for businesses with a chance to turn things around. Usually, corporations and partnerships file this type of bankruptcy, but a sole proprietorship that doesn’t qualify for Chapter 7 also can file under Chapter 11.
In Chapter 11, a company remains in business while reorganizing under a court-approved trustee. The company files a detailed plan for paying back its creditors. If necessary, it may terminate leases and contracts. The business can recover assets, repay a portion of the debt over time and be discharged from other obligations. After the plan is created, the creditors must vote. The court approves the plan if it finds it to be fair and impartial.
In every reorganization case, the debtor typically preserves ownership of the firm and tries to keep it running so they can repay creditors more effectively than they would through Chapter 7. A Chapter 11 bankruptcy may be converted to a Chapter 7 bankruptcy if the business cannot effectively rebuild. The court appoints a trustee to oversee the proceedings if this occurs.
In many Chapter 11 cases, businesses can eliminate bad debts and arrangements, such as by reducing the principal balance on mortgages tied to undervalued properties and by eliminating lease obligations that are no longer beneficial. Usually, this bankruptcy filing takes six months to two years to repay creditors and be discharged from other debts.
Prior to the COVID-19 outbreak, Congress also took steps with the 2019 Small Business Reorganization Act (SBRA) to streamline the Chapter 11 process for small businesses with less than $2.7 million in debt. The Coronavirus Aid, Relief and Economic Security Act (the massive stimulus bill passed in the final year of the Trump administration) also temporarily raised the limit under the SBRA to $7.5 million in debt, provided that 50% or more of the debts arise from business or commercial activities.
This new type of bankruptcy is already making it possible for more small businesses to restructure their debts and keep the doors open. But this new process doesn’t provide any additional protections for commercial and investment properties held by the owner.
It should be mentioned that a Chapter 13 bankruptcy is another option for sole proprietors with limited amounts of debt. Chapter 13 is known as a reorganization, whereby a court establishes a payment plan over three to five years that allows individuals and sole proprietors to keep their property.
People often confuse bankruptcy with a foreclosure, but these proceedings have much different purposes.
In a typical Chapter 7 or Chapter 11 bankruptcy, a sole-proprietor debtor can be released from paying certain debts. The court will issue a permanent order that discharges the debt, effectively prohibiting the creditors from collecting.
This can cancel a wide range of debts, such as credit cards, medical bills, lawsuit judgments and personal loans. Mortgage debt also is dischargeable, but there is a catch: The bankruptcy will not discharge the liens held by mortgage lenders on a property. By securing a lien on the property, a commercial mortgage lender will retain an ownership interest in it. In essence, a bankruptcy will wipe out the owner’s responsibility to repay the mortgage debt, but they can still lose the collateral that is secured by the lien.
A sole proprietor also has to disclose whether he or she has transferred property before bankruptcy. If this occurred within the past two years, the bankruptcy trustee can take action to recover the asset. The trustee can even file a fraudulent transfer lawsuit to recover the property.
When a sole proprietor files for bankruptcy, he or she has to attend the creditors’ meeting, where the trustee asks questions regarding assets and finances. The business owner needs to disclose whether they have transferred a property within the previous two years. Failing to disclose a transfer could result in losing a bankruptcy discharge. The debtor may even have to pay a fine or spend time in jail.
The bottom line is that bankruptcies can get complicated when real estate is involved. A number of issues can crop up that can delay a distressed-property sale. For commercial mortgage lenders and brokers, it is worth consulting with an experienced bankruptcy attorney to understand the process for any given scenario. ●