Key Provisions of Interest to Commercial Lenders

President Clinton signed into law the Bankruptcy Reform Act of 1994 on October 22, 1994. While the bulk of the Act deals with the administration of bankruptcy cases, several provisions of interest to commercial lenders are included in the Act. This letter will summarize the commercial issues addressed in the Act and comment on how the new law may affect decisions in loan underwriting and in workouts.

I. Guaranties by Insiders. The most publicized commercial issue in the Act is the provision in Section 202 overruling the Deprizio case (Levit v. Ingersoll Rand (In re V.N. Deprizio Construction Co.), 874 F.2d 1186 (7th Cir. 1989)). The holding in Deprizio, which was followed by bankruptcy courts in Alabama, extended the normal preference period from 90 days to one year if a loan was guaranteed by an "insider" (i.e., partner, shareholder, director, officer, etc.) of the debtor. The case also permitted the bankruptcy trustee to recover a preferential payment from a party that was not an insider, such as a lender.

Section 202 of the Act overrules the holding in the Deprizio line of cases by requiring that a preferential payment made more than 90 days, but less than one year, prior to the date of a bankruptcy petition may only be recovered from an insider. The Act is effective with respect to any cases filed on or after October 22, 1994. Lenders that recently have received such preferential payments thus are protected unless the borrower has filed a bankruptcy petition prior to October 22.

II. Assignments of Leases of Real Property. Lenders taking a mortgage on income-producing property generally record an assignment of leases and rents in addition to a mortgage. In many jurisdictions, including Alabama, however, it is not at all clear that a security interest in the rents generated by real property will attach to rents accruing after the filing of a bankruptcy petition. A lender in most cases must take some further affirmative step to enforce the security interest prior to the date of the petition, other than merely recording the assignment of leases and rents, such as requesting a court to appoint a receiver.

Section 214 of the Act provides protection to mortgagees by stating that a mortgage and a corresponding security interest in the rents acquired prior to the commencement of a bankruptcy case extends to the rents acquired after the commencement of the case, unless the bankruptcy court orders otherwise. As a result, it becomes more important than ever to record a separate assignment of leases and rents for income-producing property, rather than to rely on some "boilerplate" language in the mortgage. Debtors-in-possession and trustees previously could argue that the lender had not taken the necessary step to enforce its security interest prior to the filing of the petition. They now must argue that no formal security interest existed in the rents, but that the lender only had a mortgage on the real estate. This argument would be difficult to sustain in the face of a separate instrument dealing only with the rents.

III. Single-Asset Real Estate Entities. Chapter 11 of the Bankruptcy Code is designed to permit a debtor -- a legal entity -- to reorganize its business. The protections offered by the Bankruptcy Code were not intended to allow passive investors to defeat the rights of mortgagees in bona-fide transactions. Lenders have long decried as an abuse the bankruptcy protection offered to single-asset speculative real estate entities that file a reorganization petition on the eve of foreclosure when they have no equity in the property and no "business" to reorganize. The lender's attempt to foreclose its mortgage is then delayed by operation of the automatic stay.

Lenders faced with such a situation often file an adversary proceeding seeking to have the bankruptcy case dismissed as a "bad faith" filing. Such proceedings are expensive, time-consuming and not often successful. Section 218 of the Act provides some relief in single-asset cases by stating that the automatic stay is lifted (thus permitting foreclosure) unless the debtor within 90 days of the date of the petition (i) files a plan of reorganization that "has a reasonable possibility of being confirmed within a reasonable time" or (ii) commences making interest payments to the lender.

IV. Bifurcation of Mortgages on Principal Residence in Chapter 11 Cases. The United States Supreme Court recently resolved a split of authority in the courts by holding that a Chapter 13 debtor may not "bifurcate" a mortgage on the debtor's principal residence into a secured portion (equal to the value of the residence) and an unsecured portion, and thus treat the two portions differently under the Chapter 13 plan. The entire claim held by the mortgagee is to be a secured claim under the plan.

Section 206 of the Act extends this protection to Chapter 11 cases, but only if the claim is secured only by a mortgage on the debtor's principal residence. The language leaves room for arguments still being raised in Chapter 13 cases that the prohibition on bifurcation of claims does not apply if the mortgage covers any property other than the principal residence, such as furniture and fixtures.

V. Leases of and Security Interests in Aircraft, Vessels and Rolling Stock. Sections 1110 and 1168 of the Bankruptcy Code previously provided that the holder of a purchase-money security interest in or lease of certain aircraft, vessels and rolling stock may repossess its collateral unless the debtor reaffirmed the security interest or lease or cured any defaults within 60 days.

Section 201 of the Act extends the protection of Sections 1110 and 1168 of the Code to all secured parties, whether or not their security interest is a purchase-money interest.

VI. Personal Property Leases. Upon the filing of a bankruptcy petition by a lessee of equipment or other commercial personal property, the lessor often would have to await confirmation of the debtor's reorganization plan before learning whether the debtor would reject or accept the lease. If the lease was accepted, any defaults would have to be cured. If the lease was rejected, however, lessor was relegated to an unsecured claim for any deficiency or loss of income occurring prior to the time the lease was accepted or rejected.

Section 219 of the Act requires a debtor or trustee to perform the lessee's obligations under the lease arising 60 days after the date of the petition, until the lease is accepted or rejected. The lessor's exposure thus will be limited to rentals accruing for a period of two months.

The foregoing summary deals only with a few provisions of the Bankruptcy Reform Act of 1994 that are most likely to affect secured lenders. The Act contains many more consumer and administrative provisions. If you have any questions about the Act and about how it may affect your business, please contact either Bill Ratliff or Mike Brandt.