For many small business owners, Chapter 11 reorganization or Chapter 7 liquidation seems like the only reasonable response to a defaulted loan. However, a bankruptcy proceeding can be expensive and time consuming. Moreover, it may be harmful both to your company and your creditors. In some situations, bankruptcy may not be the best option or the only option for restructuring, getting back on track or closing your business in an orderly fashion. Every option has its drawbacks and benefits, but they can be preferable to filing for bankruptcy. This article looks at four alternative methods for resolving a defaulted loan: receivership, assignment for the benefit of creditors, UCC Article 9 sale and out-of-court workout with creditors.
A Neutral Third Party
The first alternative is receivership. The basic idea is that the court takes over management or the liquidation of a business and its assets. The receiver is an officer of the court and a fiduciary, and holds the property as a custodian. The role of the receiver is to hold and maintain the assets, to prevent them from being wasted, and to preserve their value until the case is over. In state court, a receiver is usually appointed at the request of a secured creditor, who fears that its collateral may be dissipated or injured. Put simply, your creditors could initiate the receivership, but the court has significant control over what happens.
If the business can’t be saved, an assignment for the benefit of creditors may be a cleaner way to wind it down. In an ABC, the business (known as the assignor) hands over all of its assets to a neutral third party (the assignee). The assignee holds those assets in trust, liquidates them, and distributes the proceeds to the creditors based on their priority levels. In other words, it’s essentially a Chapter 7 bankruptcy liquidation, but an ABC process is more streamlined and quicker, and management and creditors get to have a say in the process. But there are some caveats. For one, an ABC does not automatically stay lawsuits against the business. Second, the assignee isn’t always appointed or overseen by a court. That is the main difference from a receivership, which also relies on a neutral third party. Third, ABCs are regulated under state law, and rules vary widely from state to state, with some states having a statute, others using common law, and others not recognizing ABCs at all. Fourth, the assignee is a fiduciary who has a duty to maximize the value of the business for the benefit of the creditors - either by conducting a liquidation or by conducting a bulk sale.
Article 9 Sale
The third alternative is the Article 9 sale, which comes into play when a loan is secured by collateral. Under Article 9 of the UCC, a secured lender has the right to take possession of the collateral, sell it, or keep the collateral in satisfaction of the debt. This can be done with the borrower’s consent, which is common in “friendly” situations. But consent isn’t a requirement. After taking possession of the collateral, Section 9-610 of the UCC allows the secured party to dispose of the collateral by either a public or private sale. If the lender takes the collateral back, how will you deliver products or services to your customers? This is a critical question. Still, by agreeing to surrender the collateral and to the sale, the borrower potentially has some leverage, particularly if the borrower (or a guarantor) is anxious to be rid of the personal liability.
The fourth alternative is an out-of-court workout. A workout agreement is a restructuring of debt directly with your creditors. We should warn you, however, that this option is not always realistic. This process can be extremely efficient, and can save money and do less damage to your business than bankruptcy. Think about it from the lender’s perspective. A bankruptcy costs the lender time and money too. The target of this process is to get a consensual agreement with your creditors. This agreement would modify the amount owed or the time in which it will be paid to fit the cash available to the business. Typically, this means reducing the principal amount owed or pushing out the maturity date of the debt, or both. Sometimes these deals include the issuance of new equity. Two common forms are worth knowing. A composition agreement involves the debtor and multiple creditors who agree that each will receive a specified amount, possibly over time, in full payment of the debt. An exchange offer is the same but made to a specified class of creditors, like a class of bondholders, for example, or to a class of lenders.
More than One Exit Strategy
Defaulting on a business loan is frightening, but there’s more than one exit strategy. Each has its own upsides and downsides. Your best option depends on the kind of problem your business is facing and how your debt is set up. Some of these options focus on saving the business, while others help shut it down in an orderly way. The point is that bankruptcy isn’t the only option, and it’s not necessarily the best one.
