Commercial Loans Blog

How Bankruptcy Affects Commercial Loans - Scary Stuff

Posted by George Blackburne on Wed, May 22, 2013

Let's suppose you FINALLY (Helloooo?  Is there intelligent life out there?) came to your senses and recognized that the real money in commercial real estate finance is in loan servicing fees.  Therefore you became a commercial hard money broker.

A commercial mortgage borrower comes to you and asks you to help refinance his ballooning commercial loan.  Of course, he comes to you just ten days before the scheduled foreclosure sale, and the speculators who bought the commercial mortgage note from the bank really want to foreclose on and own the commercial property.

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You scramble as fast as you can, but it becomes clear that you won't be able to close his new commercial loan in time.  Therefore you send the borrower to a local bankruptcy attorney, who puts the LLC that owns the commercial property into a Chapter 11 (Reorganization) Bankruptcy.  For the next 60 days the note holder's foreclosure is automatically stayed.

In the meantime, your commercial mortgage refinance is now ready to close.  You obtain a letter from the Chapter 11 bankruptcy trustee saying that its okay to pay off the ballooning loan.  The borrower signs your commercial loan documents, the title company blesses the transaction*, and you close.

Two months later the borrower stops paying.  You file foreclosure ... only to get the worst news of your life.  Your mortgage is invalid!  Because the borrower had declared Chapter 11 Bankruptcy (the bankruptcy where the borrower asks for more time to reorganize his finances), title to the subject property was no longer vested in the LLC that used to own the property.  Instead, title is vested in the name of the bankruptcy estate.

Only the bankruptcy court judge can grant permission (in the form of a formal order) to the borrower to sign for a new commercial loan.  While it is the job of the Chapter 11 Trustee to marshal the assets of the bankruptcy estate, the Trustee himself cannot grant your borrower authority to sign for a new loan.

So where does that leave you?  Totally screwed.  You have an unenforceable promissory note (but no mortgage) against a borrower in bankruptcy.  As the old joke goes, "The doctor says you're gonna die."

* What about the title company?  Can you make a claim on the title insurance?  No!  Title insurance does not protect you against fraud or the execution of the loan documents by the wrong party.  That's YOUR job as the lender to make sure the right party is signing on behalf of the property owner.  The title company will usually make a good faith effort to help you verify that, but their title insurance policy specifically precludes coverage in the event that the wrong party signs on behalf of the property owner.

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Topics: bankruptcy and commercial loans