As the costs of bankruptcy continue to grow, secured lenders have increasingly looked to sales under the Uniform Commercial Code (UCC) Article 9 as an alternative to bankruptcy to dispose of secured property. While available to dispose of most types of personal property collateral, this method is particularly well suited for disposing of intangible assets. Many intangible assets can be transferred and delivered through a relatively simple assignment, rendering UCC Article 9 sales attractive to creditors disposing of intangible collateral.
In the midst of the pandemic, limited court access pushed lenders to increasingly rely on UCC Article 9 to dispose of or otherwise gain ownership of collateral. This tool continues to be an important option to recover after a borrower defaults.
In the past 18 months, lenders have been patient with their borrowers. During that time, borrowers have been able to successfully refinance obligations in a market with liquidity available. As lenders begin to face more disruptions caused by the pandemic, including supply chain disruptions that are drying up funding, it is likely that some lenders will stop supporting borrowers in 2022. UCC Article 9 sales can provide lenders with advantages when they need to dispose of collateral in a borrower’s default.
Why Choose an Article 9 Sale
Why choose an Article 9 sale?
While bankruptcy Chapter 11 can provide positive outcomes for secured lenders (including a bankruptcy sale order conveying the collateral to buyers free and clear of most liens and interests), lenders are often required to fund a budget to run a sale process in bankruptcy. In some instances, running a bankruptcy process is the only viable option due to the existence of the bankruptcy automatic stay and a borrower’s potentially complex capital structure. Chapter 11 is a good tool to bring together a multitude of parties in complex capital structures, although often at the expense of the lender.
However, it is often not cost effective to seek chapter 11 protection for loans of $5 million or less. Bankruptcy alternatives such as receiverships, assignments for the benefit of creditors (ABC), and chapter 7 bankruptcy each lead to a receiver, assignee, or trustee being appointed to control the sale process. A subchapter V process (the new Chapter 11 plan process available since February 2020) generally lets the debtor remain in possession, with a trustee in an oversight role. Most lenders do not want to hand control of the business to another fiduciary unless there is a concern for fraud. Because subchapter V is still an emerging vehicle, the outcomes of this process are still unknown. Borrowers must go through the plan process, and if there are fraud allegations, control may need to be given to a third party to oversee a sale process.
An Article 9 sale can allow a lender to dispose of collateral in a timely, value maximizing sale (for certain assets) at relatively low cost, subject to notice and commercial-reasonableness requirements. The lender maintains control over the sale process and has additional flexibility on how to dispose of assets, such as going to auction or disposing of the debt.
How an Article 9 Deal Is Structured
How an Article 9 deal is structured
A going-concern Article 9 sale is the unicorn that requires celestial alignment. This occurs when the business can be preserved, the borrower is committed to make the process successful, and the lender is agreeable to providing customary representations in the disposition process. Further, fees tend to be considerably lower than what occurs in a bankruptcy process. While possible, these kinds of going-concern deals are extremely uncommon.
More often, when Article 9 is being considered as a solution, the business is already coming apart at the seams - vendors who have not been paid are ceasing to perform services, the warehouse is holding back the inventory in lieu of payment for the overdue rent, and relationships have soured. This environment is well suited for the disposition of intangible assets. Intangible assets make good candidates for Article 9 sales because what a lender can actually deliver in an Article 9 sale process aligns with what buyers of intangible assets want to get.
Lenders commonly sell their collateral in an Article 9 sale on an “as is” basis, disclaiming warranties as Article 9 permits. Lenders are often unwilling to provide any representation beyond an as-is sale, as they do not own the collateral themselves and in many instances do not have possession of the physical goods. For intellectual property assets, however, such as trademarks, patents, and copyrights, this kind of disposal is achieved by way of an assignment of the subject intellectual property that the buyer can record with the United States Patent and Trademark Office (for patents and trademarks) or the U.S. Copyright Office (for copyrights) to update its records.
With domain names, however, a simple assignment does not accomplish the buyer’s goal of obtaining use of the asset in the short term. Without the cooperation of the borrower, the buyer cannot port the domain name to the desired registrar. Until a domain is ported to the buyer’s registrar, it cannot be used by a buyer, making borrower cooperation an important consideration. Further, if the buyer obtains the assignment of a related trademark, it may later be in a position to seek transfer of the registered domain through a UDRP action, subject to the UDRP’s requirements.
For software, source code escrows have been a valuable tool for licensees to be able to best use the rights to the source code. Having source code in an escrow enhances the ability of a lender to deliver this type of software product to a buyer. Lenders that do not have escrows available are at a significant disadvantage. Independent counsel can review whether loan and escrow documents permit release of source code to a collateral buyer.
Winning the borrower’s cooperation
An Article 9 sale will go more smoothly if the borrower cooperates. A cooperative borrower will enable an efficient deal structure, a less complicated diligence process, and management calls with buyers about the various uses of the asset. An uncooperative borrower may threaten a bankruptcy filing, which would trigger the automatic stay and could delay the sale.
Proposed cooperation terms may involve collateral rights, personal guarantee claims, transition services, or employment, each requiring separate review. Independent counsel can assess any proposed waiver and its conditions. This kind of creativity can help lenders maximize value and minimize the risk of delay.
Selling the Debt or Running the Auction
Selling the debt or running the auction
Through the sale process itself, a lender will understand what the various assets are worth ahead of the auction. Buyer interest, questions, and conversations during the process can teach a lender what assets are important and to whom, all before an auction is even held.
Those insights provide lenders with options. If the lender is not going to retain the asset, the understanding of what it is worth will help direct the lender to the best path to payment. If the lender is going to retain the asset, it provides the lender with the knowledge to target future partners.
Before moving to the auction itself, a lender can sell its debt for a certain level of payment. Debt is often sold at a discount to face value, but a buyer of the debt may be able to credit bid the full face value of the debt into the auction. The buyer of the debt obtains a chance to make an arbitrage by buying the debt at a discount and crediting the full value of the debt. The lender receives a certain payment now. Negotiations over these terms often lead to a sale of the debt.
If the collateral is headed for auction, the lender will have a good idea of who is interested in bidding from the diligence that has been requested. Auction format and bidding terms depend on commercial-reasonableness requirements and the circumstances of the sale. The presence of a credit bid sets a floor that a creative lender can leverage to benefit the next steps of its recovery.
The bottom line
The pandemic’s supply chain issues will continue to strain certain loans. The longer problems last, the more defaults there will be and the more remedies lenders will need to pursue. Article 9 sales provide an attractive opportunity to dispose of collateral, particularly with intangible assets, to provide lenders their repayment.
About Delancey Street
Delancey Street is a business debt settlement company that helps business owners nationwide. Our goal is simple: negotiate proposed debt settlements with funders, subject to their agreement. We are based in New York. We tell you how it is; because your business and future is on the line.
