Bankruptcy

Understanding Bankruptcy in Commercial Mortgages

In the context of commercial real estate, bankruptcy is a legal process initiated when a borrower—typically a business entity or a real estate investor—is unable to meet their debt obligations to a lender. When a commercial mortgage is involved, the bankruptcy filing triggers a complex series of legal protections and procedures designed to either liquidate the debtor's assets or reorganize their finances to pay back creditors over time.

The primary goal of bankruptcy in a commercial setting is to provide the borrower with "debtor-in-possession" status or a structured exit, while ensuring that the secured lender's interest in the collateral (the property) is addressed according to federal bankruptcy laws.

Key Types of Bankruptcy for Commercial Borrowers

Commercial mortgage borrowers typically file under one of two specific chapters of the Bankruptcy Code:

• Chapter 11 (Reorganization): This is the most common filing for commercial real estate entities. It allows the business to continue operating while proposing a plan to restructure its debts. For a mortgage holder, this may involve altering the interest rate, extending the loan term, or modifying the principal balance.
• Chapter 7 (Liquidation): In this scenario, the business ceases operations. A court-appointed trustee gathers and sells the debtor's non-exempt assets to pay creditors. For the commercial mortgage lender, this often leads to the sale of the property or a deed-in-lieu of foreclosure to satisfy the secured debt.

The Automatic Stay

Perhaps the most critical element of a bankruptcy filing is the Automatic Stay. As soon as a borrower files for bankruptcy, an injunction is automatically placed on all collection efforts, including foreclosure proceedings. This prevents the lender from taking possession of the property or continuing with a scheduled foreclosure sale without explicit permission from the bankruptcy court.

Lenders may file a "Motion for Relief from Stay" if they can prove that the property lacks equity or that their interest in the collateral is not being adequately protected (e.g., the borrower is failing to pay property taxes or insurance).

Impact on the Commercial Lender

A bankruptcy filing significantly shifts the power dynamic between the borrower and the lender. Key impacts include:

• The "Cramdown" Provision: In a Chapter 11 case, a court may approve a reorganization plan over the lender's objection. This can include a "cramdown," where the secured portion of the mortgage is reduced to the current fair market value of the property, and the remaining balance is treated as unsecured debt.
• Cash Collateral: Borrowers must obtain court approval to use the "cash collateral" (such as tenant rent payments) generated by the property to fund operations. Lenders often fight to ensure these funds are used exclusively for property maintenance and debt service.
• Lease Assumption or Rejection: The debtor has the right to either assume (keep) or reject (cancel) existing leases. This can significantly impact the property's Net Operating Income (NOI) and the lender’s underlying security.

Secured vs. Unsecured Status

In a commercial mortgage bankruptcy, the lender is generally treated as a secured creditor because the debt is backed by real property. If the property's value is greater than the loan amount, the lender is "over-secured" and may be entitled to recover interest and legal fees. If the property value has dropped below the loan amount, the lender is "under-secured," and the deficiency may be treated as unsecured debt, which is often paid at a significantly lower rate during the distribution of assets.