Investing in Commercial Non-Performing Notes Part IV: The Threat of Bankruptcy and The Risk of Cram Down

By Bob Bright, Esq.

In part two of this series, I briefly touched upon bankruptcy as one of the risks that should be assessed when considering investing in a non-performing note.

For most investors, their immediate goal upon acquiring a non-performing note is to either: 1) flip the note quickly and capture the spread; 2) recover the asset and sell it or hold it; or 3) workout the default with the borrower through a modification, or forbearance of the original note. Regardless of which exit strategy you intend to pursue, you need to address the risk of bankruptcy before you commit to the purchase of the note and before you commit to one exit strategy over another. Why? Because bankruptcy puts a stop to all forward momentum and, may even eliminate the option of your preferred exit strategy.

For the debtor, bankruptcy offers two main benefits: 1) in the short term, it puts an immediate stop to all outside attempts by creditors to take the debtor’s property; and, 2) it offers the potential of restructuring the debtor’s obligations through a “cram down.” In the short term, it may also strengthen the borrower’s negotiating position with the lender.

1. The Automatic Stay

Pursuant to the US Bankruptcy Code, an automatic stay goes into effect immediately upon the filing of a bankruptcy petition. A “stay” is legalese for “everybody freeze right where you are.” If you are seeking to recover the underlying asset in a foreclosure action, your case in state court just got locked down tight. If you were attempting to sell the note forward, the market value of that note has just taken a hit. And, if you were looking to negotiate with the borrower for a forbearance or a modification, you just lost some of your leverage.

Bankruptcy courts are unique in the sense that they have the immediate ability to stop all other court actions against the debtor dead in their tracks. And, this stay doesn’t even require an affirmative act by the bankruptcy court. Once a debtor has filed its petition, all that it needs to do is provide notice of the filing to its creditors. It is then incumbent on the creditors to immediately stop their efforts to collect on the debt. This includes the notifying the court in a foreclosure action that the debtor has filed bankruptcy.

Just by becoming involved, the bankruptcy court has immediate authority over all other courts and your ability to collect on the note. This is an immense power. The justification for this power is that a bankruptcy court doesn’t just have jurisdiction over the debtor, it takes jurisdiction over the debtor’s assets. In order to effectively assert that jurisdiction and manage the debtor’s assets on behalf of the debtor, and on behalf of the creditors, the bankruptcy court must be able to act without interference from all other courts. And, all other courts means all other courts. A debtor could file for bankruptcy relief in Maine and it would put an immediate stop to a foreclosure action in California. And, yes, it puts an immediate stop to non-judicial foreclosure efforts as well.

Once in place, the bankruptcy stay remains in effect potentially all the way through the discharge of the bankruptcy. There are, however, limitations to this power. For example, if the debtor is not maintaining the property and its value is deteriorating through neglect, the creditor can seek relief from the stay on the grounds that bankruptcy is not providing it with adequate protection of its secured interest. This is accomplished by filing a motion for relief from stay in the bankruptcy court. However, the court may not be inclined to hear such a motion until the debtor has had a reasonable amount of time to submit its plan for reorganization. In the usual bankruptcy case, the debtor has 120 days in which to file its plan.

2. Single Asset Real Estate Entities

For our purposes, one of the more important limitations on the bankruptcy protections are the SARE rules that apply to commercial properties. SARE stands for Single Asset Real Estate and it refers to a debtor whose primary asset is a single piece of commercial real estate from which it earns a passive income; such as through rent collection, rather than through active business operations. Originally, these rules only applied to properties valued at less than $4 million. When the bankruptcy code was overhauled by Bankruptcy Abuse Prevention and Consumer Protection Act in 2005, this limitation was completely removed. As a result, the SARE rules now apply to all single asset entities regardless of the property’s value.

SARE limits the duration of the automatic stay to an initial period of only 90 days. During this time, the debtor must either submit a plan for reorganization that has a reasonable possibility of being confirmed, or it must resume payments to the secured creditor at the non-default rate of interest. If the debtor does neither within this 90 day period, the creditor can seek immediate relief from the stay to pursue its foreclosure action.

3. A Reasonable Plan

Whether the SARE rules apply or not, the ultimate issue to be decided in bankruptcy court is whether a reasonable plan can be implemented that will allow the debtor to emerge from bankruptcy at the plan’s completion and which will provide adequate protection to its creditors. In other words, the court tries to balance the likelihood that the debtor will actually emerge from bankruptcy on a solid financial footing against the risk of causing further harm to the creditors.

What constitutes a “reasonable plan” is dependent upon a number of factors, but it ultimately boils down to a search for a solution that makes commercial sense during the life of the plan. A typical plan will last from three to five years.

In a SARE situation, the principal analysis of whether a plan is reasonable, should focus on the ratio of the debt to the value of the property. If the unpaid principal balance of the note is roughly equivalent to the value of the property, it is unlikely that a reasonable plan can be confirmed without a substantial capital injection from a third party.

Here’s why:

Let’s assume a note-holder has a matured secured interest in a commercial property valued at $2 million with an unpaid principal balance of $2 million. A typical plan under this scenario would have the debtor making interest only payments at the non-default rate during the life of the plan. Therefore, there would be no reduction in the unpaid principal balance.

At the end of three (or five) years, the debtor’s plan would have to include a resolution of the matured obligation. In other words, it would need to be refinanced. Under current underwriting guidelines, the most the debtor could obtain in refinancing would be around 60% of loan to value. With a value of $2 million, this means the borrower would need to come up with an additional $800,000 in order to pay off the balance of the original note.

In order to obtain refinancing of the entire unpaid principal balance without a capital infusion, the property would have to appreciate in value to roughly $3.3 million in that three to five years; a 165% increase in value. Stated another way, the property would have to appreciate at roughly 20% per annum in order to qualify for refinancing at the end of three years. If the plan were to last five years, the appreciation rate would still have to be 10% or better, year over year.

When you consider that commercial property values have dropped an average of 42.8% from October of 2007 to January of 2011, you can see why any plan that relies upon market appreciation will not be viewed favorably.

Conversely, the lower the ratio of the unpaid balance to the market value of the property, the greater the likelihood that such a plan may have appeal to the court. If we continue to assume a market value of $2 million, but lower the unpaid principal balance to $1.6 million, the numbers change dramatically. First and foremost, our debtor now has an equity stake in the property. This give the debtor an incentive to fight and the bankruptcy court would prefer to not see the debtor’s equity wiped out completely.

With these numbers, the property will still need to appreciate almost $700,000 in value to qualify for refinancing. However, the required rate of appreciation would drop to about 6% a year over five years. Historically, this figure can be supported with market data and, if it is attained, the property could qualify for refinancing which would allow for complete repayment of the creditor’s position. The bankruptcy court is able to assume, within reason, that market conditions will change for the better. And, they are more inclined to do so, if the alternative means the loss of the debtor’s equity position.

4. The Risk of a Cram Down.

Now, we enter a trickier part of the discussion: What happens when the unpaid principal balance exceeds the value of the collateral? If a plan doesn’t qualify as being reasonable when the property value and the note value are equivalent, how could a plan be reasonable where the property value is less than the note value? It is in this strange set of circumstances that the creditor becomes at risk for a “cram down.”

Let’s assume a situation where the property is performing, or close to performing. That is, its income is sufficient, or almost sufficient to service its debt. However, the loan to value ratio is now out of whack due to declining property values.

Let’s flip the numbers and say the property is now worth $1.6 million and the unpaid principal balance is $2 million. Under a Chapter 11 bankruptcy, the debtor could seek a cram down of the loan obligation. If approved, the court would treat $1.6 million as a secured claim and would treat the remaining $400k as an unsecured claim. For practical purposes, this means that the $400k is basically written off, as there is probably little else left in the estate to address the claims of the unsecured creditors.

The bankruptcy court can also force a modification of the loan upon the creditor that includes a new schedule of payments and a new interest rate. The court can do this, even over the objections of the affected creditor, if it finds that the plan overall is fair, equitable and does not discriminate against the dissenting class of creditors.

So, what might a cram down look like? Let’s assume the $2 million note referenced above had an interest rate of 7% and a default interest rate of 12%. The borrower is conducting operations on the property and is generating income, but is just shy of earning enough to service the debt. The non-default interest payment alone is over $11,666 per month.

A bankruptcy court could re-write the loan down to $1.6 million. It does this by recognizing the market reality that a successful foreclosure will only net the lender a property worth $1.6 million and leave it with an unsecured claim for the remaining $400k. But, the bankruptcy court can go a step further and impose a new “market” interest rate that can even be dramatically different from the original note. At least one court has held that an appropriate formula is to start with the prime rate and adjust upwards from 1% to 3% depending upon various identified risk factors.

As of the date this article is written, the prime rate is 3.25%. This would imply that a reasonable rate imposed by a bankruptcy court could range from 4.25% to 6.25%. Under our hypothetical, if the court imposed a 5.25% rate and reduced the outstanding loan balance to $1.6 million, interest only payments would be reduced from $11,666 to $7,000 per month. More to the point, this cram down took a non-performing note, converted into a performing note and just eliminated your ability to recover the property.

5. Assessing the Risk

So, how does a potential investor assess the risk of bankruptcy? The first enquiry should always be to look at what the borrower has been doing? Is the borrower still in possession of the property and are they attempting to make a valiant effort to keep things going? Does the borrower have other assets and/or is it engaged in active operations at the property in a way that could prevent application of the SARE rules. If you can, gain access to the servicing file so you can review what discussions have taken place between the borrower and lender in the past. Has the borrower been steadfast in its requests for a modification or has there been an indication of indifference on the part of the borrower? All of these considerations will help identify whether the borrower is emotionally engaged with the property and has a reason to fight to keep it.

The next line of enquiry should be to define the relationship of the value of the property to the unpaid balance of the note. The more one-sided the ratio, the more likely a bankruptcy court will be in a position to grant meaningful relief to the borrower: either by converting a portion of the note balance into an unsecured claim, or by granting relief to the borrower by restructuring the interest rate to a manageable rate.

In either situation, bankruptcy presents a real risk that needs to be assessed when determining a purchase price for the non-performing note. If there is any risk of bankruptcy, it can have a dramatic effect on your exit strategy options. At a very minimum, it can disrupt your ability to pursue recovery of the property based on the imposition of the automatic stay.

It can also increase the attorneys’ fees budgeted for your recovery efforts as you may find yourself in state court in one location and then have to retain all new counsel in another location in order to respond to the bankruptcy action. All the while, there is no return on your capital outlay in acquiring the note in the first instance.

Now for a disclaimer, this article was designed to give you an overview of some of the issues that can be raised in bankruptcy. It is by no means all encompassing and does not fully explore the myriad of issues and outcomes that can arise in a given situation. All legal matters are unique and the fact that a case with facts similar to yours was decided one way does not guarantee that your case will be decided the same. The best way to ascertain the legal risks of a contemplated course of action is to discuss those risks with your trusted counsel.

Bob Bright is a principal of Bridgewaters - Commercial Law Consultancy and serves as General Counsel for COMAC ( Bridgewaters represents clients in the US and Internationally in the acquisition, disposition and management of commercial assets and investment properties. This includes the buying, selling and resolution of distressed debt. ( Bob is dual qualified as a California attorney and a solicitor of England and Wales. He can be reached at

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Hi Terry, love this... can you post in a blog and not the forum? This way I can feature as an article...


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