January/February 2011

Lemonade Inc. — Giving the Bankruptcy Process a Great Big Hug

In the following article, SmithAmundsen bankruptcy attorneys Patrick Jones and William Hackney suggest that in some distressed situations, it might be time for lenders to take a different tack. Rather than engaging in a fight, a lender might consider “riding the horse in the direction it’s headed” to his or her advantage.

Isn’t it time lenders gave the bankruptcy process a big, warm hug? Now, hear us out…

When a borrower defaults and attempts to use the only leverage it has left by refusing to cooperate with the lender’s efforts to mitigate its loss, the lender’s inclination is to bomb the borrower back to the Stone Ages, to borrow a phrase. We all know how that can turn out — expensive and frustrating protracted litigation often presided over by a state court or federal bankruptcy judge who is unwilling to provide the bargained-for relief to which the lender is entitled. But, what if the lender took a different tack? What if the lender refused to fight with the borrower and instead went along with the borrower’s tactics and used them to its advantage? This is precisely the advice that we have been giving our lender clients with some success.

When a borrower defaults under a loan agreement, the first step is to send it a notice of default. Barring an agreement to forbear, an ability to cure the default or a refinancing of the loan, the second step is to initiate foreclosure proceedings, often in conjunction with the appointment of a receiver, especially in instances where the lender has lost confidence in the borrower’s management and its ability to preserve the value of the lender’s collateral; so far, so good. The third step is where things get complicated: the borrower files for protection under the U.S. Bankruptcy Code, bringing the foreclosure proceedings to a halt and immediately putting the borrower in a relative position of power.

At this point in the process, lenders are most often advised to fight the bankruptcy process by filing a motion to lift the automatic stay and allowing the lender to continue with the foreclosure proceeding. Depending on a variety of factors too numerous to go into here, the lender may or may not succeed, but either way, it likely loses. If the action fails, the lender is in a stalemate, which could last for years.

If the lender succeeds, the bankruptcy proceeding is — at least with respect to the lender — a nullity. The lender continues with the foreclosure action and eventually takes possession of the collateral. This is not always a favorable result for the lender — the collateral loses any “going-concern” value it once had and it now must be listed on the lender’s books, and any necessary maintenance expenses and taxes now become a liability for the lender. These costs and expenses are compounded if the value of the collateral is depreciating, as is usually the case with equipment and receivables and has recently been true of real estate.

The Alternative: Cooperate

Chapter 11 of the U.S. Bankruptcy Code allows the debtor’s management to continue operating its business, prevents the lender from foreclosing, and may even transfer control of the lender’s collateral from the hands of a state-appointed receiver, which the lender may have just paid a substantial amount in legal fees to wrest from the borrower in the first instance. So, it seems counterintuitive not to move to the lift the automatic stay, to instead allow the borrower to remain under the protections of the Bankruptcy Code. But in many cases, the lender can eliminate the cost of fighting the automatic stay and focus on using the bankruptcy process to achieve the same goal it sought in foreclosure; namely, the speedy sale of the borrower’s collateral, without assuming the costs of ownership of that collateral.

The lender can achieve these gains by seeking the appointment of a Chapter 11 trustee, if the borrower is still operating, or converting the case to Chapter 7, if the borrower operations have ceased or are significantly impaired.

A Case Study

A recent series of cases handled by our firm illustrates the successful application of this approach. After several years of delay and evasion in several state court foreclosure proceedings and on the eve of judgments of foreclosure, the borrower put each of its single asset real estate entities into bankruptcy hoping to buy even more time and further delay the inevitable sale of each parcel of real estate. However, instead of filing a motion to modify the stay, which may or may not have been granted, (and even if it were granted would have resulted in nothing more than a journey back to a laborious state court foreclosure fight), the decision was made to embrace the bankruptcy proceedings and use the borrower’s choice of forum to the lender’s advantage.

Motions were immediately filed seeking the appointment of a Chapter 11 trustee or, in the alternative, conversion to Chapter 7. Part and parcel of these motions were requests to allow the state court-appointed receiver to maintain control and possession of the assets, which were entrusted to him in the foreclosure proceeding. In general, the Bankruptcy Code provides that a debtor in a Chapter 11 case should be allowed to maintain control and possession of its own assets and operate its own affairs. However, the Bankruptcy Code also provides that under certain circumstances the debtor can lose its ability to maintain control and possession of its own assets and operate its own affairs. Under those circumstances, another party must be brought in to operate the debtor.

The lender argued in each of the bankruptcy cases that because of the debtors’ (and the debtors’ principal’s) conduct both before and after the bankruptcy case was filed, the debtors were incapable of managing their own affairs in the bankruptcy cases. Citing conduct such as failure to pay real estate taxes, failure to procure insurance and failure to protect and preserve security deposits, the lender asserted that its collateral was at risk in the bankruptcy cases so long as the debtors remained in control of their own assets and continued business as usual. Under continued pressure from the lender and the court, each of the debtors eventually agreed to surrender control and possession and assent to the conversion of the cases to ones under Chapter 7.

Through the subsequent appointment of a Chapter 7 trustee whose sole responsibility it was to liquidate the assets of the debtor (in this case the real estate), the lender was able to ensure the debtor and its principal were excluded from the continuing operations of the debtor entities and an expeditious sale of the debtors’ assets conducted. Moreover, as lenders’ balance sheets became crowded with repossessed real estate, a sale through the Chapter 7 process allowed the lender to avoid taking ownership of the real estate during the sale process.

Chapter 11 Chapter 7 Lift Stay
Initial Costs Motion to appoint trustee Motion to convert Motion to lift stay
Costs of Administration High Moderate High
Length of Proceeding Longer Shorter Interminable
Carry Costs No No Yes
Recoverable Costs Yes No No

Patrick Jones is a partner in the Bankruptcy and Creditors’ Rights Practice Group with the law firm of SmithAmundsen LLC in its main office in Chicago. Jones’s practice focuses on primarily on corporate bankruptcy and insolvency-related litigation, including lender/borrower disputes. Jones is a graduate of the University of Oklahoma and the DePaul University College of Law, and was named a “Rising Star” by Illinois SuperLawyers magazine for 2010. Jones can be reached by e-mail at pjones [at] salawus [dot] com.

William Hackney is a partner in SmithAmundsen’s Bankruptcy and Creditors’ Rights Practice Group. He represents debtors, creditors, committees, trustees and others in both Chapter 11 and Chapter 7 bankruptcy proceedings as well as all manner of out-of-court workouts and restructurings. He is a member of the American Bankruptcy Institute and a board member of the Chicago/Midwest chapter of the Turnaround Management Association. Hackney can be reached by e-mail at whackney [at] salawus [dot] com.