The Unique Ability to Modify Loans in Chapter 11 Bankruptcy
You’ve heard it before: Bankruptcy does not allow people to rewrite financial provisions in loans or mortgages. Although Chapter 7 or Chapter 13 can provide avenues to help people or businesses get out of foreclosure, just changing the terms of a pre-existing mortgage agreement is not one of them.
Chapter 11 Can Rewrite Loan Agreements
But this is one area where Chapter 11 is unique; in Chapter 11 it is possible to rewrite the terms of a loan agreement. Rewriting an agreement is permissible so long as it is fair and equitable to the creditor, and so long as the plan does not discriminate between creditors.
Extensions of Loan Terms
For example, may commercial loans have a lump sum payment due at the conclusion of their term. In other words, assume the 5, 10, or however many years long term of the loan runs out, but when it does run out, the loan is not completely paid off even though the debtor was current on all payments and not in default. But the debtor now has to make one large lump sum payment at the end of the loan.
Debtors often try to extend the term, to allow them more time to pay off this lump sum. Many lenders say no to this request. But Chapter 11 bankruptcy can force them to say yes. Courts have said that this is not unfair to lenders, as the lenders still get what they anticipated through the loan agreement, they just have to wait a little longer to get it.
In many cases, the terms of leases or mortgage contracts have been extended many years. Courts have found that the interests of the debtor in maintaining business operations outweighs the lender’s interests, since the lender will still be getting what it anticipated getting paid anyway.
Cramdowns in Chapter 11
Cramdowns also are allowed in Chapter 11. A cramdown happens when the secured creditor’s claim exceeds the value of the property secured (sometimes referred to as being “upside down”). The unsecured portion of the loan is either excused, or paid through the bankruptcy at pennies on the dollar.
Limits on Modifications
There are some limits on a court’s power to modify a loan in Chapter 11 bankruptcy. The Court cannot modify any loan that is secured by the debtor’s principal residence, except in a Subchapter V this can be allowed (something business owners should think about when leveraging their personal homes for business related financing).
Additionally, to modify a loan, there must be some showing of good faith. In cases where someone hasn’t paid a mortgage or loan payment in years, a court will be hesitant to give that debtor even more time to pay off a loan.
Rarely if ever will the court approve of a modification that simply does away with a security—that is, a debtor usually won’t be able to transform a secured loan into an unsecured loan. However, the ability to modify any type of loan is something that is still completely unique to Chapter 11 bankruptcies.