Distilled to its core, bankruptcy is commonly understood as a “debtor-friendly” tool. As a general rule, creditors do worse in bankruptcy than they otherwise would fare outside of bankruptcy. Such basic realities explain why debtors often threaten their creditors with bankruptcy, and why creditors often seek to get bankruptcy cases dismissed.

But in a case decided late last year, the 7th Circuit Court of Appeals expanded the rights of junior, undersecured lenders.

By “junior, undersecured lenders,” think of second – or third — mortgage lenders who, during the recent Great Recession, found their loans “out of the money;” that is, their “collateral” – a mortgage on a piece of property – is often worthless because the property is worth less than even the first mortgage.

Outside of bankruptcy, such junior, undersecured lenders would be wiped out. Specifically, at a state-run foreclosure sale, their mortgage and lien would be foreclosed over, with the junior lender receiving nothing.

However, in a recent decision, the 7th Circuit expanded the application of Section 1111(b) under the Bankruptcy Code. The main winners of this expansion are junior, undersecured lenders who otherwise would be out of the money.

How Section 1111(b)(1) protects wholly unsecured lenders

Though it has been part of the Bankruptcy Code for more than 30 years, Section 1111(b) is often misunderstood. The section applies in the context of a Chapter 11 plan, not in the context of a sale. It is most relevant when a debtor tries to “cram-down” a plan whereby it would retain control of a property, and the junior lender is wiped out under the proposed plan.

To make this real, an example is helpful. A debtor owns a property worth $10 million, with two non-recourse mortgages recorded against it: the first for $15 million and the second for $5 million. In this example, the second lender is “out of the money,” meaning its lien against the property is worthless. Should the first lender foreclose on the property under state law, and the property indeed sells for $10 million at the foreclosure sale, the second lender would receive nothing.

Now let’s assume that, in an attempt to save the property, the debtor files for bankruptcy before the foreclosure sale is completed, and then files a plan. In such a case, the question arises whether the second lender has a valid claim for $5 million.

In Brookfield Commons, the 7th Circuit answered, “yes,” which gives “out-of-the-money” junior lenders tremendous leverage. Whereas in a state foreclosure they would be wiped out, in the context of a bankruptcy case, they now have a valid claim that is entitled to recovery under the plan. 

The take-away is that a junior lender whose lien is otherwise worthless might actually fare better in the event of bankruptcy than it would outside of bankruptcy.

 How Section 1111(b)(2) protects partially secured lenders

Partially secured lenders quite possibly wield Section 1111(b) rights with the most power. That is, if the lender is not completely out of the money, then Section 1111(b) gives it even greater leverage.

In the example above, if the property is worth $16 million, then the second lender is “in the money,” in that it has a secured claim for $1 million and a deficiency claim for $4 million. Outside of bankruptcy, such a lender could expect to receive only $1 million from a foreclosure sale.

But inside bankruptcy, if it makes the Section 1111(b)(2) election, its entire $5 million claim is treated as secured. That, in turn, means that the debtor must fully repay the claim – in a combination of interest and principal. Otherwise, the lender can later foreclose on its entire claim in the event of default. 

The practical effect of making the Section 1111(b)(2) election for a partially secured lender is that in the event of subsequent default by the debtor, the lender then receives the benefit of any appreciation in the property. To be clear, the Section 1111(b)(2) election is not to be made lightly, as it also has competing consequences, such as elimination of any deficiency (unsecured) claim. If ever a decision required consultation with experienced bankruptcy counsel, making the Section 1111(b)(2) election is one such instance.

If used properly, Section 1111(b) of the Bankruptcy Code can be a lender’s best friend.