Opinion: Radical bankruptcy reforms may raise new issues

The Coalition has pledged a radical reform of the bankruptcy laws here bringing the regime into line with the one year period that has long prevailed in the UK.

The reform has been generally welcomed — there is no longer any low-hanging fruit to be harvested from property developers and others, and a relatively harsh regime has only served to promote the phenomenon of bankruptcy tourism where people with means go abroad to Britain.

Central Bank figures published later this week will again highlight the huge mortgage arrears problem afflicting thousands of ordinary people seven years after the crash.

But one wonders whether the authorities have fully thought through the consequences of the bankruptcy reform — not least on the losses resting on the loan books of banks.

Despite the universal welcome, the reform may well be hastening a liquidity problem for the banks.

On bankruptcy, legally, all of the bankrupt’s property transfers to the Official Assignee.

The Official Assignee will sell all assets to generate a pot from which the debts will be paid.

The bankrupt is no longer responsible for any of the debts.

If there is a shortfall, the shortfall gets written off.

The bankrupt is also entitled to maintain a level of income called ‘reasonable living expenses’.

Anything above this ‘reasonable’ income level must be put into the bankruptcy pot.

And the obligation to pay continues for a number years, even after a discharge from bankruptcy.

The point that interests us most about the ‘reasonable expenses’ rule is that it includes an amount for the bankrupt to cover their rent.

If the mortgage payment equates to the value of the rent, the Official Assignee considers the mortgage to the bank as the same as rent.

The Official Assignee is now the new owner, but has no interest in doing much about the negative equity in the home property because there is no equity to be had to add to the pot for ordinary creditors of the bankrupt.

The lender has three options. The first is to stand outside the bankruptcy and recover any debts, if necessary by repossessing the property.

Under a second option, the bank values the property and claims the balance as “an unsecured debt” from the general pot.

A third option involves handing over the property to the Official Assignee in the hope that the pot will be big enough.

Let’s take an example of a property bought with a loan of €300,000 which is now worth €200,000. The negative equity is €100,000.

From the bank’s perspective, the third option would entail giving up €200,000 and sharing in the bankruptcy pot along with everybody else.

In practice, this never happens.

Under the second option, the bank accepts that the property is worth only €200,000 and claims the €100,000 worth of negative equity hoping that it gets a share-out of, say, 1 cent in the euro. This could result in the bank getting the property and, possibly, a share-out.

Under the first option the bank believes that staying completely outside the bankruptcy leaves it entitled to full repayment of the €300,000 mortgage.

Under this scenario the bank is playing a long game, receiving some sort of mortgage repayment and waiting for the property to appreciate to a level permitting the sale and the repayment of the €300,000 mortgage in full.

The bank, however, has a big legal problem. From the moment the bankrupt is adjudicated as bankrupt, the bankrupt is no longer legally obliged to repay the loan. The bankrupt does not own the property.

In effect, the loan has now become a non-recourse loan, meaning the bank can only recover the value of the property and cannot recover anything from the bankrupt.

Outside of any possible share-out, the bank cannot recover any of the negative equity of €100,000. The bankrupt may be paying up to stay in the property and avoid a repossession and sale, but legally, the bankrupt cannot repay the mortgage.

What happens when the person is discharged from the one-year bankruptcy or when the reasonable living expenses rule runs out?

If the bankrupt and their spouse are able to get loan finance to buy the property at a market value of €200,000, they may be better off forcing a sale by stopping paying the bank and buying it.

It is cheaper to have a mortgage in some places than to rent. For the banks this could put them in an awkward position.

There may well be billions of euro worth of such negative equity shortfalls on their loan books which have yet to be fully realised.

Bill Holohan is senior partner at Bill Holohan Solicitors and has written extensively on Irish and EU bankruptcy law