Stripping Down Residential Mortgages Under the Small Business Reorganization Act: A Preview of Things to Come?

Mark W. Sandretto and Jared J. Lefevre

house with tree   The Small Business Reorganization Act of 2019 (SBRA), effective February 19, 2020, created a new, streamlined process for small business debtors seeking a fresh start pursuant to Chapter 11 of the Bankruptcy Code.  Among SBRA’s many new provisions is Section 1190(3), which negates the general Chapter 11 prohibition on modifying claims secured solely by a security interest in real property that is the debtor’s principal residence.  Section 1190(3) provides that an SBRA plan of reorganization may modify the rights of holders of claims 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 (i) not used primarily to acquire the real property; and (ii) used primarily in connection with the small business of the debtor. 

   In perhaps the first opinion of its kind, the US Bankruptcy Court for the Eastern District of New York in In re Ventura, decided on April 10, set forth a roadmap for analyzing the application of Section 1190(3).  In Ventura, the Court was tasked with analyzing whether the debtor’s proposed Chapter 11 plan impermissibly sought to “strip down” a secured lender’s claim to the value of the collateralized real estate by bifurcating the lender’s claim into a secured portion valued at approximately $1,000,000 and an unsecured claim of approximately $670,000.  The debtor’s plan further sought to pay the secured claim over 30 years at 4.25% interest but provided no provision for payment of the unsecured claim on ground that the debtor’s personal liability on the note had been discharged in a previous Chapter 7 bankruptcy.  The lender objected on multiple grounds, including as to the applicability of Section 1190(3). 

   The Court determined the language of Section 1190(3) constituted an express departure from the ordinary Chapter 11 residential mortgage anti-modification rule and that the word “primarily” is not conducive to a bright-line test. Rather, the Court concluded that the following factors were probative of whether loan proceeds were used “primarily” to acquire residential real property or used “primarily” in connection with the debtor’s small business: 

  1. Were the mortgage proceeds used primarily to further the debtor’s business interests?
  2. Is the property an integral part of the debtor’s business?
  3. The degree to which the specific property is necessary to run the business.
  4. Do customers need to enter the property to utilize the business?
  5. Does the business utilize employees and other businesses in the area to run its operations?

   While the Court reserved judgment on whether the debtor’s residence/bed-and-breakfast fit within the foregoing test, it noted there was sufficient evidence to warrant a full evidentiary hearing based on, among other things, the debtor’s use of the vast majority of the property to run a bed-and-breakfast operation, the debtor’s course of conduct in obtaining various permits to operate the business and the ancillary resort-style services offered in the property. 

  Whereas the prior Chapter 11 rule was bright-line in its application, Section 1190(3) injects some additional complexity for commercial underwriters evaluating a debtor’s default risk profile.  Moreover, because Section 1190(3) provides that claims secured “solely” by a debtor’s principal residence are subject to modification, lenders may opt to avoid offering commercial loans to small businesses secured only by residential real estate in favor of a broader collateral base in an effort to avoid adverse treatment under SBRA.  

   For additional information on SBRA, please see “The Small Business Reorganization Act of 2019” or view our webinar, “Creditors' Rights and COVID-19.”  Mr. Sandretto and Mr. Lefevre spoke at the webinar as well as authored the article.  They would be happy to answer any questions you may have regarding SBRA as well as In Re Ventura’s effects on the law. 


Disclaimer: The article in this publication has been prepared by Eastman & Smith Ltd. for informational purposes only and should not be considered legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney/client relationship.