With cash flow woes in the pandemic putting an unprecedented number of commercial real estate projects in default, savvy borrowers are using Chapter 11 bankruptcy filings in a new way to turn the tables on aggressive lenders, cure their defaults and move forward without risk.
Without a doubt, the latest data show the defaults are significant: In January, 7.37% of lodging-sector commercial mortgage-backed securities loans were delinquent and 4.36% were under special servicing, compared to 1.26% and 0.42%, respectively, for pre-pandemic January 2020.
Be that as it may, loan servicing is nowhere near the level of nondefault figures seen pre-pandemic. Hungry lenders, who can double as property managers on the hunt for portfolio additions, are recognizing these trends and targeting the following trifecta — property with (1) equity, (2) the loan for which is in technical default and (3) the borrower for which would face challenges refinancing.
In such circumstances, with deed-in-lieu arrangements and foreclosures abounding, borrowers can effectively beat lenders at their own games by entering Chapter 11 bankruptcy strategically. This approach is far from the white flag that raising such a filing may conjure in the minds of business owners. Indeed, equity remains in place, management remains in place and the secured mortgage lender is put back in its place — as nothing more than a securedmortgage lender.
In other words, this is the quintessential Chapter 11 filing as a sword, not a surrender, and despite the incredible variety in industries and loan documents, these cases play out in remarkably similar ways.
How the Borrower Finds Its Proverbial Back Against the Wall
The story of a mortgage default, particularly in the era of COVID-19, is ubiquitous.
Borrowers operate and meet their obligations under the business plans they spent time, effort and know-how putting together; an uncontrollable change in circumstance — like the pandemic — throws a wrench into that plan; the business falls behind on its mortgage; operations eventually pick back up and cash flow eventually starts to look normal again, but the hiccup set the business far enough behind that getting out in front of the mortgage default seems impossible.
At some point after the default, the lender undoubtedly called the default and began calculating default-rate interest. Not long after that, the desperate-feeling borrower likely started requesting accommodations while the lender — believing it held all the cards — may have gone so far to accelerate the debt and sit back waiting for a full payoff.
Borrowers in this position can continue to try to cut a deal, but it will likely not be long before they are served with a foreclosure complaint. In addition, the lender will often seek Joseph Pack Jessey Krehl an expedited order to get payment during the pendency of the foreclosure case and appointment of a receiver to control the property in the meantime.
The extent to which these asks will be granted is dependent on the state’s foreclosure law, but the borrower is likely already getting buried under the growing snowball. Even the threat of these actions can begin to make things look impossible.
Fortunately, as competent counsel know well, there are ways to avoid these new hurdles and refocus to what most borrowers wanted to do in the first place: Get current and back to status quo.
Prepayment Penalties — Avoiding Double Jeopardy
Many, if not most, large, commercial loan instruments will include a prepayment penalty — perhaps styled as a more friendly sounding “yield maintenance premium.” These provisions will likely provide that the borrower has no right to prepay any portion of the loan for a set period of time, and then apply certain penalties to whole or partial prepayments after that period.
These provisions can vary wildly, so it is important to review commercial loan documents with knowledgeable professionals to ensure proper understanding of — and compliance with — these provisions.
Notably, these provisions often impose the strictest penalties when prepayment comes during the continuation of an event of default. When paired with the standard right of lenders to accelerate the full amount due in the case of an event of default, borrowers may find themselves in a double-jeopardy situation.
Not only is cash flow likely constrained — thus creating a default — and not only does the borrower need to find a way to come up with the full balance of the loan despite these cash flow problems; now, the lender is seeking full payment plus some penalty for prepayment?
Fortunately, some borrowers may be able to find reprieves at state law that can provide — admittedly, jurisdiction-specific — relief.
In Florida, for example, the Supreme Court has endorsed “the general rule that unless otherwise specifically provided for in the note, the lender cannot upon the lender’s acceleration also collect the prepayment penalty.” Accordingly, in Florida, the content of the prepayment provision is key in the case of discretionary acceleration.
There is little guidance in Florida as to what precisely makes a post-acceleration prepayment penalty “specifically provided for in the note.” One 2006 case from Florida’s Third District Court of Appeals, Feinstein v. New Bethel Missionary Baptist, upheld prepayment of accelerated debt where the agreement explicitly contained the following provision:
Acceleration of the debt as set forth in this paragraph constitutes an involuntary prepayment for which the prepayment fee provided for elsewhere herein shall be due and payable. This clause specifically was bargained for as consideration for the extension of credit based upon the interest rate granted by lender.
While the provision in Feinstein represents the high-water mark of a so-called specifically provided, post-acceleration prepayment penalty, the vast majority of loan documents are not nearly so precise.
In 1996, another Third District Court of Appeals case, General Mortgage Associates Inc. v. Campolo Realty & Mortgage Corp., stated this plainly when evaluating the following prepayment provision: “The foregoing prepayment penalties shall also apply in the event borrower defaults under the terms and conditions of this mortgage.”
The court determined that this provision did not “‘specifically’ provide for recovery of the penalty after and in addition to the ‘lender’s acceleration’ and collection of default interest.” Merely providing for acceleration in the event of default in one place and separately providing for prepayment in the event of default in another does not, so it seems, provide the requisite specificity to enforce a post-acceleration prepayment penalty in Florida.
While it has not been specifically litigated, it seems likely that a general cumulativeremedies provision also would not meet this bar. Because provisions of the kind in General Mortgage are far more common than those in Feinstein, many Florida borrowers may not be faced with the double jeopardy of both being forced to prepay the full amount due and forced to pay a penalty for prepaying the full amount due.
While this article’s focus is on Florida, it is worth noting that the Sunshine State is far from the only jurisdiction to protect borrowers from this oppressive post-acceleration prepayment penalty scheme. These other courts rely on a variety of rationales in coming to similar conclusions.
For example, courts in New York, Illinois, Indiana and Arizona have held that recovery of a prepayment penalty is only appropriate where prepayment is voluntary, and, accordingly, these lenders cannot recover the penalty in a post-acceleration and foreclosure proceedings context.
Other jurisdictions, such as Texas and Washington, have determined that prepayment penalties are wholly inapplicable in the event of acceleration because there can be no prepayment of a debt that has been accelerated to become due and payable now.
Additionally, in the context of bankruptcy, bankruptcy courts have shown that they are not shy about applying Section 506(b)’s reasonableness requirement to post-acceleration prepayment penalties when assessing the allowance of a claim under 502(b).
As discussed below, this potential application of 506(b) and 502(b) is far from the only benefit debtor-borrowers may find in the Bankruptcy Code, however.
Chapter 11 Bankruptcy — A Sword to Turn Back the Clock
Notwithstanding the discussion of avoiding prepayment penalties above, a Chapter 11 reorganization under the Bankruptcy Code can provide mortgage borrowers a wealth of tools to counteract their over-zealous lenders.
As a threshold matter, Section 362 of the Bankruptcy Code imposes an automatic stay to all collection efforts the moment the bankruptcy petition is filed. While creditors, especially secured creditors, can petition the bankruptcy court for relief from the automatic stay, this is a powerful tool available to debtors. Staying the state court foreclosure action can give the debtor-borrower much needed time to formulate a strategy and seek needed financing, particularly in today’s market, where even bridge loans enjoy relatively reasonable terms.
Bankruptcy also provides a host of tools unavailable to debtor-borrowers outside of bankruptcy, and one such tool is the ability to decelerate a loan to make its payment more manageable.
Section 1124 of the Bankruptcy Code provides that, notwithstanding an acceleration clause in a loan agreement, a creditor’s claim is not impaired under a proposed plan of reorganization if, pursuant to the plan, the debtor (1) cures any defaults under the loan agreement; (2) reinstates the loan’s original maturities; (3) compensates the creditor for any damages incurred as a result of “reasonable reliance” on an acceleration clause; and (4) does not otherwise alter the creditor’s rights.
Where loans have not yet reached their original maturity date, courts have held that a borrower is legally entitled to decelerate those maturities under Section 1124(2), effectively returning them to their pre-default status quo. This is a particularly attractive option, as this deceleration and restatement renders a claim unimpaired, which means that such claim holder is conclusively deemed to accept the plan of reorganization and is not afforded a chance to vote — i.e., the lender is forced to remain as lender and will not be refinanced out.
If a debtor-borrower is able to pay its remaining nonloan debts or separately settle those, a debtor-borrower may be able to put forward a full unimpairment plan, whereby it decelerates any accelerated loans, pays all other claims in full and proceeds to confirming its plan without the need to solicit votes on its plan at all — even in Chapter 11.
While this deceleration and reinstatement is a well-settled possibility under the Bankruptcy Code, surprisingly little development has been given to the issue of whether prepayment penalties apply in bankruptcy in the event the debtor elects not to decelerate the debt.
In one such case, In re: Skyler Ridge, the U.S. Bankruptcy Court for the Central District of California refused to find that the automatic acceleration resulting by operation of law from a bankruptcy filing defeats enforcement of a prepayment fee clause because, if that were the law, a debtor could “avoid the effect of [such a] clause by filing a bankruptcy case.” The 1987 decision stated that such a result would be drastic and unfair to lenders.
In another case, In re: Imperial Coronado Partners Ltd., the Bankruptcy Appellate Panel for the Ninth Circuit held that the election to not decelerate pursuant to Section 1124 was wholly voluntary on the part of the debtor:
As [the borrower-debtor] admit[ed], this was a conscious decision on its part. In [the court’s] view, the decision to sell the property and pay off the loan was voluntary, and the prepayment premium is therefore enforceable.
More recently, in the 2010 case HSBC Bank USA v. Calpine Corp., which dealt instead with a no-call provision — a provision that categorically forbids prepayment — the U.S. District Court for the Southern District of New York held that no-call provisions are unenforceable in bankruptcy. Accordingly, it reversed the bankruptcy court’s ruling that the lender was entitled to an unsecured claim — as opposed to a secured claim — for its expectation damages in receiving prepayment, instead completely disallowing such claim.
The court acknowledged, in dicta, however, that “the notes could have provided for the payment of premiums in the event of payment pursuant to acceleration.” While prepayment penalties are more common than no-call provisions in commercial real estate transactions, this case provides a strong argument to borrowers whose lenders erroneously thought they were covered by merely forbidding prepayment.
This inconsistency — and, more importantly, the lack of development — in case law leaves debtor-borrowers not immediately clear what the result would be in the event its loan subject to a prepayment penalty is not decelerated — i.e., remains accelerated.
There exists a bona fide argument that such prepayment fees constitute claims for unmatured interest, which are wholly disallowed in bankruptcy pursuant to Section 502(b)(2) of the Bankruptcy Code. It appears more likely however, that such prepayment fees give rise to a general unsecured claim for expectation damages, as the above-cited cases indicate.
The law is far from settled, however, and there is ample room for clever debtors to bring novel arguments in negotiating payoffs of their mortgages pursuant to a Chapter 11 plan.
What is clear, however, is the general understanding that state law determines the substantive rights of parties in bankruptcy — i.e., whether a claim is enforceable in bankruptcy and the degree to which such claim is enforceable in bankruptcy. To that end, the arguments available to borrower-debtors at state law are equally applicable in bankruptcy.
While it is not uncommon to think of a bankruptcy filing as the last place to hide, the tools available in bankruptcy — in particular deceleration under Section 1124 and the disallowance of unmatured interest under Section 502(b)(2) — may instead be wielded as sword to fight off overzealous lenders. What is well known to bankruptcy professionals is becoming more common knowledge to borrowers after the onset of COVID-19: Lenders do not hold all the cards, and tactical filings under the Bankruptcy Code can put them back in their place.