Bankruptcy

Bankruptcy is a federal court proceeding under Title 11 of the United States Code that provides individuals or businesses with legal protection from creditors and a structured path to resolve overwhelming debt. Borrowers typically file bankruptcy as a last resort — often to stop a pending foreclosure — and the filing immediately triggers an automatic stay that halts all collection activity, including foreclosure proceedings, until the court lifts the stay or the case is resolved. For mortgage note investors, understanding bankruptcy is essential: it affects your collection rights, your lien position, and your resolution timeline.

Chapter 7 vs. Chapter 13

The two bankruptcy chapters that note investors encounter on residential mortgage files are Chapter 7 (liquidation) and Chapter 13 (reorganization). Each has different mechanics, timelines, and risk profiles:

Chapter 7: Fast Resolution, Lower Risk

Chapter 7 is a liquidation proceeding. The court-appointed trustee identifies and sells non-exempt assets to pay creditors, and the borrower's personal liability on dischargeable debts is eliminated. For note investors, the key point is that liens secured to the property survive Chapter 7. After discharge, you can no longer pursue the borrower personally for the debt through the promissory note, but you retain the right to enforce the lien against the property through foreclosure.

The critical variable is occupancy. If the property is owner-occupied, the homestead exemption generally protects it from liquidation — meaning your lien stays in place and the borrower keeps the home. If the property is non-owner-occupied (an investment property), it is non-exempt, and the trustee may sell it to pay creditors. In that scenario, you may actually receive a payoff through the bankruptcy if sufficient equity exists.

Chapter 13: Longer Timeline, Higher Stakes

Chapter 13 is a reorganization plan lasting three to five years. The borrower proposes a repayment plan, the court approves it, and a trustee collects and distributes monthly payments to creditors. Chapter 13 is the more dangerous scenario for junior lien holders because it introduces the possibility of a lien strip or cramdown.

If the total of all senior liens equals or exceeds the property's fair market value, the junior lien is wholly unsecured — and the bankruptcy court can strip it entirely. This makes the equity position above the first lien the single most important data point when evaluating a loan in Chapter 13 bankruptcy. However, roughly two-thirds of Chapter 13 plans are dismissed before completion. A dismissed case voids all proposed lien strips and restores your lien to its original position.

The Automatic Stay

When a borrower files for bankruptcy, the automatic stay takes effect immediately. This federal injunction prohibits all creditors — including you as the note holder — from:

• Continuing or initiating foreclosure
• Contacting the borrower to collect the debt
• Recording assignments or filing lawsuits related to the debt
• Taking any action to enforce the lien

To proceed with foreclosure on a property in active bankruptcy, the creditor must file a motion for relief from stay and receive a court order granting permission. This process adds time and legal expense but is routine for secured creditors with valid liens.

Researching Bankruptcy on PACER

Bankruptcy research is conducted through PACER (Public Access to Court Electronic Records) at pacer.gov. The step-by-step process:

1. Search the case — Use the PACER Case Locator with the borrower's Social Security number (recommended) or name to find the correct case
2. Review history and documents — Pull the full docket to see every filing, motion, and order
3. Read the voluntary petition — Locate the borrower's schedules listing all assets, liabilities, secured and unsecured creditors, and stated intentions
4. Focus on Schedule D — Identify all secured claims, the borrower's stated property value, and balances of all liens secured to the property
5. Check for motion for relief from stay — Look for any motion for relief filed by the senior lien holder, and the court's order granting or denying it

Discharged vs. Dismissed

The distinction between a discharged and a dismissed bankruptcy is critical:

• Discharged — The borrower successfully completed the bankruptcy process. Personal liability on the note is eliminated, but the lien on the property survives (unless stripped in Chapter 13). Collection language must shift from pursuing the debt to pursuing the lien — consult an attorney in your jurisdiction for proper compliance.
• Dismissed — The bankruptcy failed. The borrower did not complete the plan or meet the requirements. All proposed modifications, lien strips, and cramdowns are voided. The loan returns to its pre-bankruptcy status, and normal collection and foreclosure rights resume.

Impact on Note Pricing

Banks and institutional lenders rarely sell loans with active bankruptcies. They typically pull those assets from a trade portfolio and wait for the case to resolve before selling. In the secondary market, however, loans with active or prior bankruptcies appear regularly. These loans often trade at a discount because of the added complexity, making them opportunities for investors who know how to read the case files and assess the true risk.