By Ralph Preite and Kyriaki Christodoulou
Early in 2020, at the height of the global Covid-19 pandemic, the U.S. Congress passed legislation making Economic Injury Disaster Loans (EIDL), among others, available to businesses to help them survive during the storm of shut down and reduced economic activity accompanying the pandemic. The loans were administered by the U.S. Small Business Administration. Many loans did not require personal guarantees of repayment by the owners of the businesses which borrowed the EIDL funds. However, most, if not all, EIDL loans required borrowers to pledge all their assets as collateral to secure repayment of the loans. In that regard, in conjunction with the loan, the SBA placed a lien on the business borrower’s assets via a UCC filing to secure repayment. Payment of the EIDL loans was deferred until late 2022.
Now that the loans are coming due, businesses that have not fully recovered from the storm of shut down and reduced economic activity during Covid find themselves in the unfortunate position of not being able to repay their EIDL loans because the minimum monthly payments, although probably fairly commercially reasonable, are too large for some business to service. If such business borrowers fail to pay their EIDL loans, the SBA may sue for nonpayment. Further, upon obtaining a judgment for the unpaid loan, the SBA can effectively shut down the borrower’s business by seizing its collateral, which is all the business’ assets that were pledged to secure repayment of the loan when originally extended.
Chapter 11 bankruptcy, particularly the subchapter V variant of chapter 11, may help a business borrower reduce the amount of the SBA EIDL loan and simultaneously keep its assets which serve as collateral for the loan.
In bankruptcy, secured lenders like the SBA with its EIDL loans, often face the prospect of recovering less than the full value of their loans. This frequently arises when the lender’s collateral is worth less than the amount of its claim, and the borrower is unable to make loan payments. With respect to the SBA, if the SBA’s collateral is worth less than the amount of its loan, the SBA is deemed “under-secured” in bankruptcy parlance. If the value of a secured creditor’s collateral declines, say due to a pandemic-induced recession, the lender may be under-secured. For example, a restaurant’s assets – tables, chairs, kitchen equipment – may be appraised at a value well below the loan balance. This can leave the lender with a large under-secured claim.
In chapter 11 bankruptcy, under-secured claims may be bifurcated into two parts, each with a separate claim: (i) a secured claim for the value of the collateral, and (ii) an unsecured claim for the remainder of the creditor’s claim. This is implemented using §506(a) of the Bankruptcy Code. The secured portion of the claim is typically paid in full perhaps in instalments over time, while the lender’s unsecured part receives little or nothing along with other unsecured claims.
Coupled with the likelihood of receiving little to nothing on the unsecured portion of its newly-bifurcated claim, under-secured creditors face a dire situation. This is where it gets interesting. Even though the secured creditor is under-secured, and the borrower is proposing to bifurcate the claim into two parts (secured and unsecured), the creditor lender is not without rights. It can elect to treat its claim as fully secured.
In chapter 11 cases, a secured creditor has the option of avoiding the bifurcation of its claim entirely by “electing” to have the entire amount of its allowed claim treated as secured, even if the amount of the claim far exceeds the value of the collateral. This election is found in §1111(b) of the Bankruptcy Code. Many factors are relevant to a lender’s decision in making the election, including whether the lender thinks the collateral will increase in value quickly in the near future, or if there is a likelihood of the borrower defaulting under the chapter 11 plan which proposes to bifurcate the claim. This process often starts the give-and-take negotiation in Bankruptcy Court and can result in a mediated or settled outcome. Alternatively, litigation ensues, starting with appraisals and valuation hearings concerning the collateral. Nonetheless, the process of bifurcating a secured lender’s claim can be a boon to a business borrowers faced with repaying large EIDL loans.
The ability to bifurcate a loan using §506(a) of the Bankruptcy Code in some circumstances can provide a debt-laden business with a path out from under a heavy debt load. However, the election afforded to a secured lender under §1111(b) provides the lender with a useful tool when it believes market conditions may recover, or the borrower has under-valued the collateral, or the borrower will be unlikely to fully perform its obligations under its proposed chapter 11 plan. Either way, chapter 11 bankruptcy may assist in forcing creditors such as the SBA to renegotiate its secured claims to assist a struggling business address its debt burden.
KI Legal stands ready to take on such a claim. Please contact KI Legal by calling (646) 766-8308, or emailing email@example.com, to discuss your particular situation with our experienced Bankruptcy & Restructuring Division.
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