With economic uncertainty caused by rising interest rates, supply chain issues, and record inflation, many lenders see a wave of bankruptcy filings on the horizon. Considering this, a lender often asks what steps it can take to mitigate risk. Lenders also frequently ask when they should worry about bankruptcy. The best answer to both questions is bankruptcy risk needs to be addressed before a loan is approved and funded. It is too late to try and mitigate bankruptcy risk after a loan has been funded or after a loan has become troubled credit.
Why are lenders concerned with bankruptcy? According to the American Bankruptcy Institute, there were 33,184 bankruptcy filings during September 2022, a 7% increase over total bankruptcy filings during September 2021. In addition, there were 1,994 commercial bankruptcy filings during September 2022, a 16% increase compared to September 2021. Small business filings under Subchapter V increased by 79% from September 2021 to September 2022. Although September numbers reveal an increase in bankruptcy filings, whether this trend continues remains unknown as year-over-year bankruptcy filing are down, according to the American Bankruptcy Institute, 9%. Nevertheless, with borrowers experiencing cash flow problems, uncertain or diminished collateral values, increasing absorption rates for rentals and sales, and natural disasters, it is not unreasonable to expect lenders to see a gradual increase in borrowers filing for bankruptcy protection over the next 12-18 months. With this uncertain economic background, below are some steps lenders can take to help avoid bankruptcy risk.
The first step a lender can take to mitigate bankruptcy risk is utilizing sound underwriting practices when evaluating each loan, which involves undertaking a thorough review of the borrower, any guarantors, and the real property collateral, before a closing occurs and the lender’s funds are disbursed and placed at risk. Depending on the type of real property collateral, underwriting a loan may be as simple as reviewing an appraisal of the property and projecting the property’s value. With other types of real property collateral, underwriting will require a more in-depth analysis of the property’s cash flows, a review of a certified rent roll, and the credit worthiness of key or anchor tenants. For loans involving construction projects the lender must determine the absorption rate for sales or rentals. No matter the type of property, the key is to understand and evaluate the nature of the property and the risks inherent with the property. A second step a lender can take to mitigate bankruptcy risk is to document the loan transaction properly. This process will include a thorough review of a borrower’s and guarantor’s credit and financial strength to determine if they can repay the loan or if repayment relies on the sale of the property. Another crucial step requires a lender to review the entity documents of each borrower and guarantor to ensure the appropriate authorization and execution of loan documents. Finally, all lenders should obtain and review a title commitment for real property collateral to ensure the borrower has (or will have) a marketable title to the real property collateral at closing. This process also enables the lender to confirm the lien priority and the perfection of the lender’s security instrument.
Even after a loan has closed, there are steps a lender can take to help prevent a bankruptcy filing. Upon learning a borrower is distressed, a lender can work with the borrower by providing a workout strategy that will enable the borrower to restructure their loan and avoid a default situation that could lead to a costly bankruptcy. A reasonable workout structure is in the best interest of both the lender and the borrower. At this point, the lender will again underwrite the borrower, any guarantors, and the real property to see if a workout is feasible. Examples of loan workouts include: (i) renewing or extending loan terms; (ii) providing additional funds to complete a project; and (iii) structuring the payment terms of a loan, including deferring or waiving default interest and late fees. Regardless of the accommodations provided to a borrower, a lender should require the terms thereof to be reduced to a written agreement that is signed by the borrower and any guarantors.
If a lender takes all possible precautions, completes a thorough underwriting of a transaction, and provides the borrower with reasonable workout options, sometimes there is still no escaping a borrower’s bankruptcy filing. Once a bankruptcy filing is made and the lender receives notice of the filing, the lender will need to take immediate steps to protect its position.
- STOP all collection efforts. Due to automatic stay provisions in the US Bankruptcy Code, upon receipt of notice of a bankruptcy filing, the lender should immediately stop all collection efforts and seek bankruptcy counsel.
- Review the loan terms and loan documents to see if there are any holes in the documentation. A key focus will be on confirming the lender has a perfected lien or security interest in the collateral.
- If the loan was assigned to you by another lender, ensure a clear chain of assignments supports your ownership of the loan.
- Compile and review the borrower’s payment history, which ensures compliance with the loan terms, including the application of payments, assessment of fees and costs, conditions to charging default interest, and notice requirements.
- Compile and review servicing history. Include any correspondence with the borrower and/or their representatives, and any internal notes concerning conversations with the borrower.
- Determine whether the borrower has previously filed for bankruptcy relief, and if so, when and where.
- Obtain a valuation or appraisal of the property.
With economic uncertainty, lenders need to be aware of the potential for a rise in loan defaults that could lead to an increase in bankruptcy filings. Dealing with economic uncertainties is a challenge that all lenders must now face. It is critical for lenders to take the steps outlined above to protect their investments to the greatest extent possible.