A forbearance agreement was held unenforceable by Bankruptcy Judge Laura K. Grandy of East St. Louis, Ill., where the debtor had agreed to waive enforcement of the automatic stay and to permit the lender to record a deed in lieu of foreclosure after the deadline for paying off the mortgage.

In her February 13 opinion, Judge Grandy based her decision in part on finding that enforcement of “the stay waiver in this case would benefit no one other than [the lender].”

The debtor owned a hotel and restaurant that evidently had a standing mortgage for about $10.5 million. The lender had liens and mortgages on all of the debtor’s real and personal property.

The debtor did not repay the mortgage on maturity but continued making mortgage payments. Five months later, the lender and the debtor entered into a forbearance agreement, giving the debtor a 75-day deadline for paying off the mortgage.

The forbearance agreement required the debtor to sign a deed in lieu of foreclosure to be held in escrow. After the payment deadline, the lender had the right to record the deed.

But there was more. The forbearance agreement prohibited the debtor from filing bankruptcy before the payoff deadline or less than 91 days after recording the deed. If the debtor did file bankruptcy and the property was held to be an asset of the estate, the debtor would consent to a modification of the automatic stay.

The debtor filed a chapter 11 petition before the payoff deadline. You know what happened next: The lender filed a motion to enforce the forbearance agreement and modify the automatic stay.

Waivers Don’t Protect Creditors Generally

Judge Grandy began her analysis of the merits by focusing on the stay waiver. She said, “It is well established that contractual waivers of the right to file bankruptcy are generally prohibited.” On the other hand, “there is a split of authority as to whether prepetition waivers of the automatic stay are enforceable.”

Judge Grandy said that “cases that uphold waiver provisions focus largely on public policy considerations and tend to be single asset cases, or cases where the bankruptcy was filed in ‘bad faith.’” Those cases, she said, reason that enforcing waivers furthers public policy favoring settlements and out-of-court restructurings.

The “trending position” among courts enforcing waiver does not focus on enforceability. Instead, Judge Grandy said, they “treat the waiver as just one of several factors to be considered in determining whether ‘cause’ exists to lift the automatic stay.”

Judge Grandy decided that “the better approach is one that declines enforcement of such provisions,” citing bankruptcy court decisions from Nebraska and North Carolina in 1996 and 2017. The Nebraska court, she said, concluded that the debtor did not have the capacity to make decisions like a debtor in possession. The North Carolina court saw waivers of the stay as being unenforceable as a matter of public policy.

Like the two courts, Judge Grandy held “that pre-petition . . . waivers are per se unenforceable” because the court is charged with protecting “the rights and interests of the debtor-in-possession and all creditors under the Bankruptcy Code — not just those of the creditor asserting the waiver.”

The Illinois Supreme Court Had the Answer

Based on Illinois law, the lender contended that the debtor no longer held an interest in the property. Specifically, the lender argued that the forbearance agreement only gave the debtor a contingent, reversionary interest that was lost when the debtor failed to redeem by the deadline. Indeed, the lender’s theory found support in several federal cases interpreting Illinois law.

Instead of federal caselaw, Judge Grandy focused on the relevant Illinois statute and decisions by the Illinois Supreme Court. The state’s mortgage foreclosure law says that the term “mortgage” includes “every deed conveying real estate,” although an “absolute conveyance in its terms, which shall have been intended only as a security in the nature of a mortgage.”

Citing the Illinois Supreme Court, Judge Grandy said, “One of the primary reasons for construing such transfers as equitable mortgages is to ensure that mortgagors retain their redemption rights.” Citing an Illinois appellate court, she said that the “doctrine of equitable mortgage applies specifically to deeds executed after the creation of the debt, such as forbearance or refinancing agreements.”

Judge Grandy noted that contrary decisions “did not discuss equitable mortgages.”

Citing two more Illinois Supreme Court cases, Judge Grandy held:

Given the conditional nature of the instrument and the Agreement’s failure to forgive the indebtedness upon execution of the [deed in lieu], the Court finds that the [deed in lieu] in this case was, at best, an equitable mortgage and did not convey the Debtor’s right title and interest to the Properties.

Finding no other grounds for modifying the automatic stay, Judge Grandy denied the lender’s motion because there was “no cause for granting relief from the automatic stay.”