In this building block blog we look at one of the more radical changes that the SBRA makes to the law applicable to the reorganization of a business’s debts- the ability to modify the terms of any loan secured only by your personal residence. In the past, loans against personal residences were sacrosanct. Bright line rule. If the loan was against your personal residence, it could not be modified. Not so anymore. Not if you qualify for the SBRA.
If you qualify for the SBRA the new rule is as follows: notwithstanding section 1123(b)(5) of this title, a plan of reorganization may modify the rights of the holder of a claim secured only by a security interest in real property that is the principal residence of the debtor if the new value received in connection with the granting of the security interest was— (A) not used primarily to acquire the real property; and (B) used primarily in connection with the small business of the debtor.
Let’s break this down piece by piece. The new law says that notwithstanding prior law, a plan of reorganization may modify the rights of a loan against your principal residence. The law, however, does not identify what types of modifications are possible. And since this is brand-new, there isn’t much in the way of past authority to guide us on what types of modifications have been allowed in the past under different chapters of the bankruptcy code. Clearly, a loan against the personal residence can be bifurcated into a secured and unsecured portion if the property is worth less than all of the loans combined. This happens in bankruptcy quite often. For example, if there is a first loan of $300,000 and a second loan of $200,000 and the home is only worth $400,000 within the first loan of $300,000 is fully secured. The $100,000 of the second loan is secured, the balance of $100,000 is unsecured. In an SBRA action, the reorganization plan would treat the unsecured portion of the whole loan just like a credit card. It would bifurcate the currently existing second and place the unsecured portion in the same category with other unsecured creditors who typically get pennies on the dollar through the plan, if that.
Theoretically, the loan could be modified in a myriad of other ways. Changes to interest rates. Modification of balloon payments. Modification to loan term. In my opinion, the law would allow these types of modifications as they are not specifically excluded. The statute is written broadly that typically means that courts will interpret it broadly.
The second element of the new law is that the loan can be secured onlyby a security interest in real property that is the principal residence of the debtor. So if the loan is secured by any other asset plus the personal residence in a strict reading of the statute that would mean that the loan could not be modified. That seems unfair and arbitrary especially where the two loans could be modified if each was a stand-alone loan secured each by different collateral that is worth less than each of the loans.
So to this point we know that a plan can modify a loan secured only by the principal residence. What type of modifications are allowed and whether the loan can only be secured by the personal residence to be modifiable, as discussed above, are still open questions. The law, however, adds two more qualifications. First, the loan was not used primarily to acquire the real property and, second, the loan was used primarily in connection small business of the debtor. In the one case to date addressing this issue, the court said that the test to determine if these two conditions are met is as follows: was the principal purpose of the debt to provide the debtor with a place to live or were the mortgage proceeds primarily for the benefit of the debtor’s business activities?
Let’s apply this test to different scenarios:
- Scenario one. In order to fund the business, client takes out a second mortgage for $200,000 and uses all of the loan proceeds to fund the business. This loan would qualify for modification.
- Scenario two. Same as scenario one except the client only uses $75,000 of the $200,000 loan to fund the business. This loan would not qualify since the loan was not used “primarily” for business activities. Primarily means at least 50% +1 dollar.
- Scenario three. Client has a bed-and-breakfast. There are five living spaces. Four are for guests. Client lives in the fifth. Client obtained a single mortgage to purchase the business. However, in order to qualify for a lower interest rate client signed a form saying that the loan would be used only to purchase a principal residence. Here, the loan would qualify for modification regardless of the statement regarding principal residence because bankruptcy law looks at substance over form.
And, once again, once a loan qualifies the question is what types of modifications are allowed. Lenders will almost certainly argue that no modifications to the loan are allowed unless the property is worth less than the loans. I hold to the view, and will propose this in any plan I submit, that the whole range of modification options are available. Time will tell. Courts will rule on this. And those decisions will identify the full scope of modifications allowed.
To find out more about the modification of loans secured by your principal residence and the other powerful tools available under the SBRA to protect the business you enjoy and a way of life that you have worked hard to achieve, sign up to attend one of our webinars or call to schedule an appointment to discuss the particulars of your case. The initial consultation, up to one hour, is at no charge. The webinars are free, and include a 20 minute question and answer session at the end. We would also refer you to the blog and video blog sections of our website for discussions on other topics and points of interest, including case studies where we apply the individual principles covered in these building block videos to real life fact patterns.