When a commercial loan goes into default, it is not uncommon for the borrower or guarantor (or both!) to enter bankruptcy. A bankruptcy filing by the borrower or guarantor has serious repercussions for a lender seeking to liquidate its collateral. The most serious and immediate of these repercussions is the automatic stay imposed under Section 362 of the federal Bankruptcy Code.
The automatic stay enjoins all collection activities against the individual or entity in bankruptcy. The stay is also effective immediately upon the filing of the bankruptcy petition with the bankruptcy court. In this context, “immediately” means down to the exact second the petition is filed. In other words, lenders and other creditors are sometimes subject to the stay days (or even weeks) before they are notified of the bankruptcy filing.
The scope of the automatic stay is broad. It enjoins all collections activities and any other creditor actions to take possession of collateral or exercise control over collateral. Debtors commonly utilize the automatic stay to halt a foreclosure sale. Once the debtor files bankruptcy, any foreclosure sale of the debtor’s property is immediately stayed and will remain stayed until the automatic stay is lifted by the bankruptcy court.
Lenders also should be aware that the automatic stay prevents them from perfecting a security interest in the debtor’s property. For example, if a lender through inadvertence, mistake or neglect fails to file a UCC-1 financing statement or record a mortgage or deed of trust prior to its borrower’s bankruptcy filing, the automatic stay prevents the lender from perfecting its security interest after the bankruptcy filing. Lenders that fail to perfect their security interest prior to the bankruptcy filing will be treated as unsecured creditors in the bankruptcy, unless they are granted a post-bankruptcy lien by the bankruptcy court.
Additionally, Lenders should be careful when invoicing individuals or entities in bankruptcy. A lender violates the automatic stay if it sends the debtor an invoice that includes any obligations that the debtor incurred prior to the bankruptcy filing.
The price for violating the automatic stay can range from trivial to very, very serious. Some ambitious debtor’s counsel will seek sanctions against lenders and other creditors who inadvertently send account statements or invoices after the debtor files its bankruptcy petition but before the lender or creditor is notified of the bankruptcy filing. These types of suits are typically settled for annoyance value. If, however, a bankruptcy trustee notices a pattern of violations from the same lender or creditor over multiple cases, the trustee can refer the matter to the U.S. Department of Justice for further investigation. A lender could face serious monetary sanctions in each case where it violated the stay. The Justice Department also could impose monetary and non-monetary sanctions on a lender for systemic or habitual stay violations.
Lenders can protect themselves by implementing clear and precise policies for handling a bankruptcy filing by one of its loan obligors. Lenders need to be proactive if they learn a bankruptcy filing is imminent. If a lender has any doubt regarding how to proceed, it should consult experienced bankruptcy counsel to avoid sanctions or a visit from Justice.
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