How can a lender use an Article 9 sale to restructure a defaulted business loan?

For asset based lenders seeking to grow new business lines while limiting their losses, Article 9 of the Uniform Commercial Code offers one of the most holistic and efficient tools they can turn to. It is a practical path for distressed businesses and their creditors to navigate the insolvency maze and structure an out-of-court financial reorganization.

Article 9 reorganization is a controlled short sale of the business’ assets to maximize their value. At its heart the core idea is that a shutdown hurts everyone.

This method has the smallest number of losers. Everybody important gets most of what they want. The owner can move on. The buyer can enter at lower price. Jobs stay in the area. Junior creditors can write off the debt.

Combined these actions create gains instead of the liquidation losses you see with a bankruptcy or an auction. Junkyards recycle cars. Article 9 reorganizations recycle businesses. Both add to the general good.

Having survived COVID, many businesses face an uncertain future. As former government support programs phase out, they have to find new business models. There are things from pre-COVID that are gone. Some are forever. The federal government can make people spend. What it can’t do is make them buy from you. Even where record stimulus has kept their cash in the black, online competition has steadily gotten bigger, faster, and smarter. The ones that survive will be the ones that adopt a new way of doing things. Stagnation equals strangulation. Lenders can help these distressed companies keep afloat. Using Article 9 of the Uniform Commercial Code they can orchestrate a change of control to a new owner and management team better suited to a fast changing economy.

It is not an option that appears on the usual list of choices for distressed companies, lenders, or other professionals. Harvey Gross is president of HSG Services and Executive Director of IFA Northeast. Gross argues that all creditors, debtors, their CPAs, their attorneys, and, it goes without saying, every turnaround professional should understand how a non-bankruptcy reorganization works.

Take one deal. The first position bank sold all the assets to a new company owned by the former CFO, CEO, and COO. They became the owners, but they never owned the company before. There was no bankruptcy, no 363, no auction. The new company brought in ABL and factoring financing. The owner personally guaranteed the deficiency balance and got an employment deal with the new company to help cover it.

Liquidation would have killed the business, maximized bank losses, and cut jobs. The out of court deal turned in a going-concern premium and preserved the owner’s income. The bank got more than it would have from a liquidation. For the new owners it was a chance to gain market share. For the community a business stayed alive.

Article 9 Sales

Article 9 governs secured creditors’ remedies after default. Under Article 9 senior lenders have a way to sell the business outside court. The drafters found the way they were doing things with litigation was too costly, too time consuming and ineffective. They start with the collateral and build the solution around it. Article 9 has developed over time as a way to avoid court, avoid potential litigation, and allow all parties to work together to resolve it by themselves.

For business owners who have not yet adapted, and the clock is winding down, it may be time to use Article 9 as a lifeline. But lenders and investors can only help a troubled borrower if they spot the problem right away and start working with Article 9 as soon as the first signals of distress appear. Like turning a supertanker around, it does not happen overnight. When businesses start to think about it, they are already in distress. The sooner they get a grip on it, the better the chances they can make a move and get back on their feet.

Good name, bad rep. The idea of an Article 9 sale does not have a particularly good one. Ask any vendor, owner or accountant. From the name it sounds like a way to shut down a business. Article 9 sales have existed for decades. It got wrapped up with distressed assets and liquidation. Article 9 does not mean shutdown. During the time it takes to work through the issues the business keeps running. If a lender has to find the right way to handle defaulted loans, then using Article 9 as a tool to get some cash in the till is reactive. They’re fixing a problem. But using it as a way to turn around companies that are not right for a traditional ABL deal, those that other lenders are staying away from, is proactive.

While article 9 is not the answer to every problem, it is a good one for secured lenders restructuring troubled loans or exiting poor quality deals. It is probably one of the best ways to maximize collateral recovery. It limits potential challenges from other creditors.

What’s worse than buying used restaurant equipment? Selling it. Used restaurant gear, heavy equipment, and retrofitted machinery are perfect examples of what bankers are bad at selling, and for obvious reasons. It is not the sort of thing they specialize in. They are not set up to sell anything. Banking is a completely different industry. Auctions are a lightning fast way to close the books. They’re also a fast way to get the lowest price. But there are a few who know the selling process and can do well at it.

The auction block is the end of the line. Article 9 of the UCC lets secured lenders skip the legal quagmire of foreclosure and liquidation. Instead they can sell the assets to a new entity. A smart use of this tool can preserve the value of a business as a going concern. By using it, secured lenders can get an outcome that leaves the secured lender better off than they would be if they put the assets through liquidation.

Bankruptcy is not cheap. In general using Article 9 is cheaper and faster. What Article 9 sales give lenders is pretty much the same thing bankruptcy does. But without the same cost. Every judicial proceeding eats up money. The court process is highly formal. As the assets are picked over, they get eaten up. It also gives debtors a chance to cut some personal obligations while also keeping some key people employed, where there’s been no fraud.

Say a company is for sale and the prospective buyer needs financing to buy it. Incumbent lenders can fund the transaction and grow their portfolio. If the lender agrees to finance the purchase of a distressed business, it can work for everybody. The right fit and situation can be a real win-win.

The Article 9 process is also more straightforward, and it can start as soon as the lender recognizes a problem in one of its loans. It will move forward faster and with less obstruction than a liquidation. Liquidation is costly, time consuming and unpredictable. A liquidation drags out the recovery process. Using the Article 9 process also leaves more control in the hands of the lender.

The sale wipes out junior liens and encumbrances. The business keeps operating. Equipment, inventory, receivables all keep generating cash. By cleaning out the collateral, it sets the stage for the new owners to bring ABL financing in. They get clean going-concern collateral a lender can fund.

Fund Deals Other Lenders Would Stay Away From

In Gross’s view, asset based lenders with this tool at hand can have a special advantage. It gives lenders a way to fund deals other lenders would stay away from.

A 363 sale has to happen inside a bankruptcy filing. The court presides. For an assignment for the benefit of creditors, every party has to agree. By contrast, under Article 9, none of these steps is required. The subordinated creditors and members of the trade have no control over anything in a liquidation, either.

This can be a way to keep or grow the lender’s relationship with the client. To fund growth, for example, where the ABL cannot fully lend against the collateral. Or to reorganize it through a sale in a way that turns a near-bankrupt situation into a healthy deal to lend to. What you wind up with is a new company with a skilled management team taking the old business’s brand, customers, and revenue with them, while leaving the lender’s remaining debt behind in the shell of the old company. Bankruptcies leave only losers. They damage the reputation of an otherwise strong company.

Nancy Kalman of United Capital Funding, a senior business development officer there, says the firm has turned down deals without a first lien position. This reorganization strategy gives the lender the chance to do deals their policies do not currently permit.

For a lot of companies that survived COVID, what they now face is a different economy than they used to have. They can see some normalcy returning, but they don’t really know what normal will look like yet. So what comes next?

Defaults go with a normalization of the lending markets. They always have. It’s not a question of whether there will be defaults. It’s a question of how many. The case for doing some planning comes down to what defaults look like when they finally come. Nobody knows for sure. Those who can handle defaults without being blindsided will put themselves in the best position possible. Owners and asset based lenders have a chance to work together in the exit and capitalize on new opportunities for growth. It keeps people out of court and the fees that come with it.

Workouts don’t fit on a spreadsheet. There is no one-size-fits-all deal, where everybody follows a list of steps and comes out of it with the same result. But Article 9 is a tool and a powerful one. Much of the distress is hidden. As long as there is distress, there will be opportunities. But by knowing how it works, it helps you spot opportunity when you have it, and to get more out of your recoveries when you don’t. Creditors should get this. Turnaround professionals should get it. Most of all any business owner heading toward a cash crunch needs to see it and start putting it to work sooner, not later.