Can loan security be conditional on bankruptcy or death?

May 17, 2013 9:21 AM

Is it possible to write a loan contract which effectively secures the debt against the borrower's property only in the event of bankruptcy or death of the borrower? I.e., as long as the borrower is in control of his financial affairs the lender has no right to the secured assets even if the borrower defaults, but if the borrower dies or goes bankrupt the security kicks in, so that the debt has priority for any third-party trustees managing the estate?

This is in New York State. I don't actually need a clause like this, but I was writing up a contract for a rather large loan to a friend, and I got curious about whether it's possible. Seems like it would be a nice thing to have for a friendly contract, basically saying "I trust you to pay me back, but if things go pear-shaped for you I want it to be easy for you to prioritize this loan relative to the demands of any other creditors."

posted by Estragon to Work & Money (4 answers total)

Best answer: Yes, there are contract terms that work something like this. Best example is reverse mortgages work approximately like this: you borrow against an asset, and don't have to repay until the first to occur of your sale of the assets, moving (control of the asset), or death. It wouldn't be a case where you have "no rights" over the collateral, but you wouldn't be able to foreclose / repossess the collateral before death.
posted by MattD at 9:28 AM on May 17, 2013

I don't think you could make it conditional on bankruptcy. Or rather I'm not sure "conditional on bankruptcy" is anything different than a traditional secured loan.
posted by JPD at 9:40 AM on May 17, 2013

You can google "springing lien" but in general I don't think this works.

basically saying "I trust you to pay me back, but if things go pear-shaped for you I want it to be easy for you to prioritize this loan relative to the demands of any other creditors."

This pretty much goes against the entire concept of bankruptcy law, which is to provide an orderly reorganization/liquidation of your assets and debts and treat all similarly situated creditors equally so that they don't have an incentive to grab whatever they can and elbow everyone else out of the way.

There is a whole thing in bankruptcy law with "preferential transfers" or "preferences" where the trustee can undo a lot of transactions made in the 3 months leading up to bankruptcy (or longer if they were made with an insider) to prevent some creditors from getting more than others unfairly. You could also google "ipso facto clause" which is not quite the same thing, but a similar idea.
posted by payoto at 9:44 AM on May 17, 2013 [1 favorite]

Best answer: As payoto says the bankruptcy clause would not work. Even if it were in the contract, the bankruptcy court would almost certainly not allow it to be enforced.

It's not clear why any lender would NOT want a security interest in case of default on his/her particular loan but would want security interest in case of a bankruptcy filing. But if that's what you want, what you could do is make the loan a standard secured loan which accelerates (becomes immediately due and payable) in case of bankruptcy filing or death of borrower) and then make the underlying loan terms sufficiently generous that it would be impossible to default (i.e. no scheduled interest payments or PIK, 100 year maturity, no amortizations, etc). It gets you to roughly the same spot.
posted by limagringo at 10:32 AM on May 17, 2013