On March 27, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) became law. The new law contains several temporary amendments to the Bankruptcy Code, some of which apply in the business bankruptcy context and some of which apply in the consumer bankruptcy context. All of the changes are effective only for one year from March 27. In addition, the CARES Act requires creditors to grant forbearances on federally-backed mortgage loans and imposes a 60-day moratorium on foreclosures related to such loans. These key provisions of the CARES Act impact lenders and are discussed herein.
Increased Access to New Small Business Bankruptcy Provisions
Small businesses often struggle to reorganize in bankruptcy. To address this issue, Congress passed the Small Business Reorganization Act of 2019. The act took effect in February 2020 and makes small business bankruptcies faster and less expensive. At the time of enactment, the act only applied to business debtors with secured and unsecured debts less than $2,725,625.
The CARES Act expanded small business eligibility to take advantage of the recent amendments to the Bankruptcy Code. Now small businesses with up to $7.5 million in debt (with some qualifications) may seek relief under these new provisions.
Notable provisions of the Bankruptcy Code available to more small businesses include:
Appointment of a Trustee – The new small business subchapter provides for the appointment of a trustee who will help facilitate reorganization and may monitor payments to creditors under the debtor’s confirmed plan.
Streamlining Reorganization – Only the small business in bankruptcy can propose a plan of reorganization, which must be submitted within 90 days of the bankruptcy filing. The court does not have to approve a separate disclosure statement, reducing the time and expense necessary to confirm the debtor’s plan. Absent an order from the court, the new small business bankruptcies will not have committees of unsecured creditors. This will further reduce costs of bankruptcy for small businesses.
Elimination of the Absolute Priority Rule – In a typical reorganization, the small business must pay unsecured creditors in full if the owners wish to retain their equity interests. This requirement is no longer applicable to eligible small businesses. Rather than paying all creditors in full, owners can keep their interests by confirming a plan that does not discriminate unfairly among creditors, is fair and equitable, and provides that the small business will contribute its projected disposable income to the plan.
Modification of Certain Residential Mortgages – An individual who operates as an eligible small business may modify a mortgage secured by a residence if the underlying loan was for commercial purposes. This is a change from prior law that generally prohibited modification of mortgages secured by a principal residence.
Delayed Payment of Administrative Expense Claims – The new subchapter for small businesses does not require payment in full of priority claims – including for goods and services provided to the small business during bankruptcy – on the effective date of the plan. A small business debtor may now stretch payment of these claims out over the term of the plan, which will last three to five years.
Discharge Limitations – The scope of the discharge of debts for the small business will depend upon the terms of the plan and the consent of creditors. If creditors contest the plan, exceptions to a discharge, such as fraud and breach of fiduciary duty, will apply to the small business debtor. This is a departure from a typical business reorganization that has very limited exceptions to discharge.
There is little doubt that the economic turmoil stemming from the outbreak of COVID-19 will increase small business bankruptcy filings. There is a one-year deadline for small businesses with debts up to $7.5 million to file cases under the new subchapter of the Bankruptcy Code. Lenders must be prepared for these new and unique bankruptcy cases.
Current Monthly Income in Consumer Bankruptcy Cases
One notable change under the CARES Act is the amendment to the definition of “current monthly income” in the Bankruptcy Code. The CARES Act exempts from “current monthly income” any “payments made under Federal law relating to the national emergency declared by the President under the National Emergencies Act with respect to the coronavirus disease 2019 (COVID-19).” The phrase “current monthly income” is used at various places in the Bankruptcy Code, including in the “means test” used to determine whether a debtor is eligible to quickly liquidate and obtain a discharge under Chapter 7 or instead must seek relief under another chapter of the Bankruptcy Code requiring a commitment of future income toward the repayment of creditors. A debtor’s “current monthly income” also impacts, among other things, the amounts to be paid to creditors during a case and the length of time a debtor must make payments to creditors under a plan, also known as the “applicable commitment period.”
The intent of this provision of the CARES Act is three-fold. First, it prevents debtors from being ineligible for relief under chapter 7 solely due to increased income from federal stimulus checks in connection with COVID-19. Second, it prevents the stimulus check from being intercepted by a bankruptcy trustee to pay creditors in the bankruptcy case. Finally, the CARES Act prevents the stimulus check from causing an enlargement of time a debtor must commit income toward the repayment of creditors. In essence, the CARES Act ensures that the debtor in bankruptcy is able to use the stimulus check in his or her discretion. This provision may prevent a slightly higher recovery on unsecured debts, but it likely will not have a significant impact on secured debts, where the lender’s collateral drives its recovery.
Extension of Time to Complete Confirmed Bankruptcy Plans
A potentially more impactful change to the Bankruptcy Code under the CARES Act is an amendment allowing the debtor to modify a confirmed Chapter 13 plan. The court may approve a chapter 13 plan amendment “if the debtor is experiencing or has experienced a material financial hardship due, directly or indirectly, to the coronavirus disease 2019 (COVID-19) pandemic.” It also allows a Chapter 13 plan to be extended up to seven years (compared to an existing maximum plan period of five years) from the date of the first payment under the plan, subject to court approval. This amendment will allow Chapter 13 debtors to suspend plan payments for a period of time or reduce their monthly payments to the trustee and still receive a discharge under the protection of the Bankruptcy Code.
From the lender’s perspective, this provision of the CARES Act could have an impact on recoveries. With respect to unsecured debts, a modification to the plan could reduce the amount of money paid in by the debtor, meaning creditor recoveries could be reduced. Even if the payments are not reduced, the plan extension could lead to a delayed recovery. For lenders with secured claims, there likely will be no reduction in recoveries. However, there may be a delay in recovery. For example, a mortgage default that was being cured over 60 months now may be cured over 84 months, delaying the timeframe for the lender’s recovery.
Forbearance and Foreclosure Provisions
The CARES Act allows consumers who have been financially affected by the COVID-19 pandemic and who have a federally-backed mortgage to seek a forbearance of their mortgage payments for up to six months, with a possible extension of up to an additional six months. If the consumer seeks such a forbearance and attests to a hardship, the lender or servicer is required to allow for this forbearance. During the forbearance time period, extra interest and fees will not accrue, and the suspension of payments under the forbearance will not impact the borrower’s credit rating. At the end of the forbearance, the payments will come due, provided the consumer and servicer do not reach another arrangement regarding those payments.
For consumers in bankruptcy, all interested parties must receive notice of the payments that are required during the bankruptcy case. While the consumer and servicer may be aware of the forbearance terms under the CARES Act, they must provide such notice to the court and the Chapter 13 trustee as well. Unfortunately, this forbearance does not fit into the generally neat boxes defined by the Federal Rules of Bankruptcy Procedure or the electronic process for filing bankruptcy pleadings and notices. As courts continue to develop their own preferred processes for handling CARES Act forbearances, lenders and servicers may provide notice on the general bankruptcy docket or may provide notice on the court’s claims register.
The CARES Act prohibits a servicer of a federally-backed mortgage loan from initiating the filing or advancement of foreclosure proceedings or the execution of foreclosure-related evictions or sales for a period of 60 days beginning on March 18, 2020. For the purpose of the foreclosure moratorium and forbearance requests, federally backed mortgage loans include those purchased by Fannie Mae, Freddie Mac, insured by HUD, VA or USDA or directly made by USDA. This would include any loans in which the lender or servicer obtained relief from stay in the bankruptcy case and was moving forward. Finally, while the CARES Act does not specifically prohibit a lender from filing a motion for relief from the bankruptcy stay during the foreclosure moratorium, it may be worthwhile for lenders to refrain from filing motions for relief during this period. Some courts might consider the filing of a motion for relief from stay as an advancement of a foreclosure that is prohibited under the CARES Act.
James Bailey and Chris Hawkins are partners at Bradley law firm. James has experience with both debtor and creditor representation in bankruptcy, out-of-court workouts and restructurings, and bankruptcy-related litigation. He also regularly represents commercial lenders and mortgage servicers in federal court commercial litigation.
Chris represents clients in a wide variety of bankruptcy and insolvency-related matters across the country. He represents debtors and creditors in out-of-court business restructurings and Chapter 11 bankruptcy cases. Chris represents creditors and financial institutions in bankruptcy-related litigation. In recent years, he has devoted the majority of his practice to advising large financial institutions on bankruptcy compliance and bankruptcy-related regulatory matters.