Article 9 Restructuring refers to a pre-packaged going concern secured party sale transaction that aligns the incentives of the bank (or other non-bank senior lender) and borrower to leverage the first position creditor’s rights codified within the Uniform Commercial Code.
In an Article 9 Restructuring, senior secured creditors exit non-performing credits at asset value cleanly, because debtor consent, the purchaser, and the take-out financing are all pre-packaged as part of the restructuring transaction.
Furthermore, senior secured creditors are no longer resigned to simply write off deficiencies upon exit, but instead they may be able to look to the new purchasing entity itself, divorced of previous legacy liabilities, as a more viable path to the recovery of deficiency balances.
“For those banks not as knowledgeable and experienced in how the Article 9 Restructuring works, it would be advisable to be educated on this,” said James Van Horn, partner with Barnes & Thornburg.
While distress and insolvency have historically yielded an adversarial stance between bank and borrower, in an Article 9 Restructuring, the two main stakeholders in a distressed business scenario are aligned within the resolution process.
Because the Article 9 Restructuring (sometimes referred to as an Article 9 “structured exit”) is led by the senior secured lender, the process is preferential in two key aspects that overcome historical friction points for the bank:
First, because the process pre-packages debtor consent to the secured party sale, asset value is recovered without legal morass and inefficiency, meaning a higher net recovery value. At the core of the pre-packaged transaction are seller incentives afforded to the bank’s guarantor, providing them a path to participate within the newco (as non-owners), which deliver debtor consent to the secured party sale, thus aligning bank and borrower in the sale transaction. With pre-packaged debtor consent, the senior lender is able to recover asset valuation while avoiding litigation, cost, and collateral deterioration through the streamlined, consensual exit at asset value.
“An Article 9 Restructuring depressurizes what has likely been a challenging and lengthy situation for all parties involved—it’s easier to understand and quick to execute,” said David B. Scott, managing director, corporate finance at Newpoint Advisors Corporation.
Second, the senior lender no longer needs to accept asset value with a write-down of deficiency balances upon exit. Instead, the newco itself represents a path to additional recoveries for the senior lender based on performance.
The Article 9 Restructuring further aligns senior lender and borrower by staking both in the performance of the new operating entity purchasing the assets. Historically, the bank has not been staked in the upside of relaunching business assets on the other side of a judicial process. This has typically been the domain of distressed investors, with incoming purchasers being the primary beneficiaries of relaunching assets post-distress. However, the Article 9 Restructuring is uniquely lender led, rather than led by the investor.
Distressed business scenarios are most often characterized by the adversarial nature of misaligned incentives—between bank and borrower and among creditors themselves. Borrowers with no remaining options, other than filing Hail Mary chapter 11s, cost the bank time, money, and collateral depreciation.
By result, the scales can be rebalanced to more equitably distribute the benefit and upside of relaunching the assets within a newco. Through the Article 9 Restructuring process, the bank can look to the newco purchasing the assets as a preferential path, divorced of other creditors, for the recovery of deficiency balances.
“Locking in the key players and fashioning a bank’s exit via an Article 9 Restructuring can efficiently limit the costs and remove the unpredictability inherent in judicial proceedings,” said Aaron Hammer, partner at Kilpatrick Townsend & Stockton LLP.
Transaction Overview
The Article 9 Restructuring aligns the incentives of the four parties necessary to the transaction— the bank (or other non-bank senior lender), current business owner, new purchaser, and incoming take-out lender.
Debtor consent to the sale is pre-packaged with incentives providing them a path to resolve personally guaranteed deficiency balances and / or potentially earn equity in the newco in the future.
The bank is incentivized by the ability to exit at asset value more quickly and at less cost, along with a path to recovering deficiency balances from within newco.
A purchaser is identified for a private sale transaction, typically a closely held buyer (such as a current C-level employee or general manager).
Value is established by third-party appraisal in a private sale format, preferred because these “frequently result in higher realization on collateral for all concerned”. (Comment 2 to Section 610 of Article 9.)
A financial advisor evaluates the post-transaction balance sheet, cash flow, and trajectory of newco to determine to what extent bank deficiency balances may be collected and under what terms in the new operating entity.
As the incoming senior lender, an asset-based lender (ABL) conducts third-party appraisals and due diligence during underwriting.
The bank’s asset sale transaction to the new operating entity, financed by the incoming ABL, will close after the statutory notice period.
In newco, the incoming ABL takes a first position lien on the assets divorced of all previous junior liabilities. The bank (i.e., the previous senior lender) has subordinated some or all its deficiency balance as a “sub note” below the ABL, with the expectation of recovery based on performance or a take-out event such as recapitalization or sale.
Redressing Moral Hazard of Creditor Equality
Distressed business scenarios are most often characterized by the adversarial nature of misaligned incentives— between bank and borrower and among creditors themselves. Borrowers with no remaining options, other than filing Hail Mary chapter 11s, cost the bank time, money, and collateral erosion. Formal liquidations carry these costs along with reputational risk to the bank. Assignments for the Benefit of Creditors (ABCs) give a forum to junior creditors to cause delay and expense, even though they have no financial interest in the assets being disposed of and, therefore, are not technically interested parties.
At the point of insolvency, unless the first position lender is overcollateralized then there are no other financially interested parties since there is no remaining value to spill down the list of priority. Yet, whether in a Chapter 11 or a judicial ABC, the bank finds its interests compromised as judicial standards prioritize the equitable treatment of all creditors, often at the expense of the senior secured creditor. This dilution occurs through the accumulation of costs (including legal, financial advisor and trustee fees, and “hostage” or carve-out payments to unsecured creditors), in addition to time and possibly collateral deterioration.
In short, a judicial standard of not prejudicing any creditor has the practical consequence of prejudicing the one creditor who should in fact be treated preferentially— the senior secured creditor.
“There is certainly a risk for the lender in Chapter 11,” said Vincent J. Roldan | Partner, Mandelbaum Barrett PC. “Chapter 11 cases go sideways. The lender must fund the borrower’s operations and professional fees and other administrative expenses (and) the lender may end up incurring significant legal fees. Also, in a Chapter 11, the lender may have to face an aggressive unsecured creditors committee investigating liens and causes of action.”
The pre-packaged Article 9 Restructuring redresses this imbalance by acknowledging a senior lender’s rights and creating a mechanism to exercise them, outside of court and without permissions required or forum given (outside of statutory noticing requirements and commercial reasonableness) to parties with no technical interest in remaining value.
Aligning Bank & Debtor
The hallmark of a transactional process (or of any business transaction for that matter) is that incentives are aligned within a marketplace by self-interest, not by judges or trustees. Markets will arrive at equilibrium and align parties and self-interests by definition, if there is to be a transaction. In the Article 9 Restructuring, the preservation of the going concern business itself creates the incentives necessary to align the interests of key stakeholders— specifically, bank and borrower.
In the Article 9 Restructuring, debtor consent to the secured party sale is pre-packaged through incentives allowing them to add value and participate in the new operating entity. Through these incentives, the debtor has a path to resolve personally guaranteed deficiencies in the previous operating entity, and to meaningfully participate in, add value to, and earn within newco. For the debtor, this path and the solution it represents constitutes the incentive to consent to the secured party sale— while precluding any incentive for a bankruptcy filing at the 11th hour.
The bank is thus able to exit a credit at asset value cleanly, without litigation, collateral deterioration, reputational risk, or the time and expense associated with formal liquidation.
The expedited process helps avoid the deterioration of asset values that can occur during lengthy bankruptcy proceedings. This can be crucial for senior secured lenders needing quick resolution,” Hammer said.
Recovering Deficiency Balances
On the other side of a judicial asset resolution process (i.e., 363 sale or ABC), a buyer-investor will likely be the main beneficiary of relaunching those same assets failed by the previous operating entity. As such, the entire distressed investment landscape can be seen as one in which the senior lender’s remedies are diluted by the protections of all other parties—and where any future upside generated by previously distressed assets will benefit incoming parties rather than existing stakeholders currently in distress. This represents a historical friction point for banks exiting distressed credits.
However, an Article 9 Restructuring is uniquely led by the key stakeholders in a distressed business scenario, namely the bank and the borrower, rather than by a distressed investor. As such, not only are both aligned in the foreclosure process and secured party sale, they are also aligned in the performance of the new operating entity, in which both may be staked.
For the bank, newco itself becomes a preferential path for the recovery of deficiency balances. In an Article 9 Restructuring, the bank is being taken out of the collateralized piece of their loan by an ABL, which is financing newco’s purchase of the assets from the bank. In parallel, a financial advisor (FA) or consultant is likely representing the bank’s interest in structuring how and to what extent the deficiency balance can be subordinated to the new ABL, and when it may become performing— sometimes immediately, sometimes interest only for a determined period with a balloon, sometimes after a forbearance, etc. While there is no guarantee that the new business can make the bank whole, one thing is certain: A newco divorced of legacy liabilities is a more viable path to recovery for some or all the first position deficiency than was oldco.
As part of the pre-packaged transaction a financial advisor or consultant will work with the bank and the new business to understand what recovery value may be supported (and when) based on performance metrics achieved. This negotiation balances the interest of the bank with the viability of the new business.
Additionally, the financial advisor or consultant will work to determine whether any additional previous liabilities should be inherited by the new operating entity. Critical vendors can be carried over to the purchaser if doing so is in the best interest of the business because the Article 9 Restructuring process does not impose the same preferential restrictions presented in bankruptcy or other reorganization methodologies.
“The ability of the incumbent lender to potentially recover deficiency loan balances over time under an Article 9 structured exit is obviously one of the headline benefits of this methodology,” said Justin A. Barr, SVP/regional credit executive and special assets director at Carter Bank & Trust. “In some cases, all or a portion of the deficiency could even, arguably, remain on book. Another less obvious but significant benefit is the ability of the incumbent lender to negotiate the maintenance of the associated depository business.”
Case Study 1
In a recent transaction, an HVAC company that specialized in commercial jobs found itself with significant junior and trade debt, stagnating revenues, and increased costs—all contributing to a default on their bank debt. The summary of the company situation is as follows:
Annual Revenue: $15,000,000
With the seller incentives and debtor consent in place, an Article 9 sale was conducted for the benefit of the first position bank that resulted in an ABL lender funding the purchase of the assets and the bank subordinating the remaining deficiency of $1.3 million resulting in the following transaction:
Annual Revenue: $15,000,000
By using the Article 9 Restructuring, the first position creditor was able to take an under performing loan, pay down the collateralized portion through an ABL takeout, and collect the remaining deficiency balance plus interest out of the newco. As a result of the process, the business removed all the junior secured debt and the unsecured accounts payable to free up significant cash flow that resulted in a post restructuring coverage ratio of 1.61x.
Case Study 2
In another transaction, a diesel distribution company was struggling from a cash flow perspective due to a shortage and rapid increase in the cost of diesel fuel. The company was already fully leveraged with bank debt and junior debt it took on to fund growth and had no additional sources of capital. Facing imminent default and rapid decline of revenue, the first position bank and the debtor were faced with the following fact pattern:
Annual Revenue: $35,000,000
Using a pre-packaged Article 9 Restructuring, the bank was able to exit the collateralized portion of the loan and turn the entire deficiency balance into an interest only note in the newco. Working with a FA, the note will pay principal and interest once hitting certain EBITDA benchmarks. The end result was as follows:
Annual Revenue: $35,000,000
To restate the value proposition of this rebalancing from the bank’s point of view: While it may not always be the case that newco can support full recovery of the first position deficiency, it is certainly the case that newco offers a more viable path to do so than oldco.
Secured Debt Coverage Ratio (after Article 9 Restructuring): 1.7x
An Idea Whose Time Has Come
By overcoming a friction point that often incentivizes the bank to hold a credit too long, the bank no longer needs to just settle for asset value or go down with a sinking ship.
Instead, the senior lender becomes a stakeholder in the performance of the new operating entity, which becomes a path for senior lender deficiency balance recovery—a path that is preferential to the senior secured lender because it is servicing first position debt only, divorced from previous junior liabilities.
To restate the value proposition of this rebalancing from the bank’s point of view: While it may not always be the case that newco can support full recovery of the first position deficiency, it is certainly the case that newco offers a more viable path to do so than oldco.
In short, the alignment of free-market incentives between bank and borrower that facilitates the secured party sale and exit without judicial process also preserves and relaunches the business operation in which both now have a stake.
“At a time when bankruptcy has become so expensive and lengthy that secured lenders are loath to fund a Chapter 11 proceeding and companies are afraid they could not survive the delays, Article 9 Restructuring offers a cost-effective path to resolution and recovery,” said Baker Smith, managing director at BDO Consulting.
As the cost of bankruptcy soars, and where out-of-court options are generally understood to be preferable, Article 9 Restructuring represents a market-based, transactional path for resolving distress through the creation and alignment of incentives, rather than through the judicial resolution of disputes. As a transactional process, rather than a judicial one, it avoids historical inefficiencies while rebalancing the scales in favor of senior secured lenders, all while preserving jobs, business value, and economic activity.
