As if buying distressed debt is not challenging enough given the underlying business considerations, the possible, and perhaps likely, bankruptcy filing of your soon-to-be borrower presents a maze of issues the note purchaser should consider before acquiring the debt.

1. Know Your Seller

A note buyer should inquire about allegations by the borrower or its other creditors of seller misconduct (e.g., exerting control over borrower operations, overextending the loan without borrower board approval, breaching promises made to the borrower). Lender misconduct could produce negative results in the borrower’s bankruptcy, from loss of the right to vote on a plan to subordination of the loan to junior debts or even equity. A buyer without notice of such wrongdoing might succeed in purchasing the debt without ultimately inheriting the seller’s liability. Depending on the nature and magnitude of the seller’s misconduct, however, the buyer may be forced into substantial litigation about the relevance of its knowledge and, assuming such relevance, what the buyer knew or with reasonable diligence should have known about the seller’s conduct. Rather than sticking its head in the sand and hoping that litigation is not brought, or for a favorable ruling, the more prudent course is for the buyer to investigate and to consider the risks of purchasing debt from a seller accused of misconduct.

2. Know Your Sponsor

The buyer should inquire as to the character of the borrower’s sponsors (i.e., the ultimate project owners), and whether they intend to place the project into bankruptcy, and adjust the purchase price accordingly. The seller should be able to answer those questions. If not, ask the sponsor directly. Otherwise, search various bankruptcy-filing databases available on the Internet for information. If the sponsors previously have put projects into bankruptcy, the buyer should thoroughly review the pleadings and other papers filed by the borrower. Among other things, the buyer should investigate the causes of the prior bankruptcy filing, whether the borrower aggressively underestimated the property’s value in the case (in an effort to impose a mortgage write-down), and the extent and nature of the borrower’s vote control planning (in an effort to obtain plan confirmation over the lender’s objection—i.e., a “cramdown”). Certainly, buyers will want to know the results of any such cases. Buyers should beware of sponsors who have a history of placing properties into Chapter 11 and should seek a price adjustment that accounts for the likelihood of substantial litigation in the event of borrower bankruptcy. Or, in such instance, the buyer should consider simply not purchasing the note.

3. Know Your Loan Documents

The buyer should study the loan documents carefully, because they will be tested and likely applied literally in the borrower’s bankruptcy. The buyer should be sure that the seller has not intentionally or inadvertently bargained away any of the rights that a mortgage holder would normally exercise in the bankruptcy of its borrower (e.g., to oppose any type of motion or exercise any other right afforded creditors under the Bankruptcy Code). If there are special rights that the buyer is counting on (e.g., waiver by the borrower of the automatic stay), the buyer must ensure that appropriate provisions are contained in the existing loan documents. Moreover, the buyer should determine the level of the borrower’s compliance with restrictions (e.g., separateness provisions for special purpose entities) contained in the borrower’s organizational documents and representations and covenants in the loan documents. Otherwise, the buyer may be confronted with a request by the borrower to substantively consolidate (i.e., merge the assets and liabilities into a single debtor) with one or more debtors. This would introduce new creditors to the case, which, in turn, may reduce the ultimate impact of the buyer on the results of the borrower’s bankruptcy proceeding.

4. Know Your State and Local Laws and Courts

Ultimately, the buyer may be required to enforce its contractual and other rights against the borrower and, therefore, it will be critical to understand the state and local laws and the judicial temperament of the courts of the jurisdiction where the property is (and any guarantors are) located. A buyer should note that it is possible, though generally unlikely, for a debtor whose sole asset is real property to file bankruptcy in a jurisdiction other than where the property is situated. In such a case, the state law of the property’s jurisdiction would still apply to state law questions, but the bankruptcy law of the jurisdiction where the case is filed would be followed. The buyer should be cognizant of such matters as whether the foreclosure process is judicial, quasi-judicial or non-judicial; how long the foreclosure process typically takes; and whether a right of redemption after foreclosure exists. The buyer also should understand what the likely outcomes will be in the event that it seeks to enforce rights that may be contained in the loan documents (e.g., appointment of a receiver, breach of contract, suit on the guaranty), as well as factors (e.g., overburdened local courts) that impact the time frames and possible costs involved.

5. Know Your Bankruptcy Law and Judges

It is important that the buyer of a distressed note understand how real estate bankruptcies and legal issues critical to such cases are handled by the bankruptcy court for the jurisdiction where the property is located. A substantial body of case law exists throughout the country addressing important issues in single-asset real estate bankruptcy cases. These issues include dismissal for bad faith filing; permitting separate classification of trade claims from the lender’s unsecured deficiency claims (i.e., gerrymandering) for plan voting; designating creditors beholden to the debtor as insiders to exclude their plan votes; permitting shareholders to retain their equity by contributing new money (i.e., what is known as the new value exception to the absolute priority rule); and substantive consolidation (i.e., judicial merger of two or more debtors). Furthermore, knowing the judges who may be deciding the issues and, if possible, their perceived tendency to favor debtors also could be significant. It also is important that the note buyer consider the nuances of the local procedures (e.g., those involving lenders obtaining relief from the automatic stay).

The lender’s default and the bankruptcy rights of the parties are important pieces in the overall picture of purchasing distressed debt. Analyzing the foregoing considerations ahead of time, and knowing whether the applicable law is favorable to a buyer’s positions and interests, will enable a note purchaser to understand the parameters of these rights if the note is purchased and, perhaps, to price the transaction accordingly.