Originally published in American Banker on April 07, 2023, 5:00 a.m. EDT
Resolving troubled commercial loans can be messy — lawyers are needed, court appearances are routine, and emotions can run high for borrowers.
But experts are touting something called an Article 9 sale as a better alternative to bankruptcy for banks and credit unions, at least in some cases, that keeps them out of court. Article 9 requirements are outlined in the Uniform Commercial Code, a set of laws that dictate commercial transactions in the U.S.
“It definitely is more advantageous to banks,” said Val Venable, an instructor for the National Association of Credit Management, a nonprofit for commercial credit professionals. “It’s easier for them to offload underperforming loans and less expensive for them.”
Still, some lenders are not using this tool to their fullest advantage, experts said.
“There are certainly some banks that are educated enough to explore this,” said James Van Horn, a partner and restructuring attorney with Barnes & Thornburg and global president of the Turnaround Management Association, an organization for insolvency and restructuring experts. “But for those banks not as knowledgeable and experienced in how this works, it would be advisable to be educated on this.”
Banks and credit unions have enjoyed strong credit quality as federal stimulus and enhanced unemployment payments have buoyed consumers and businesses during the pandemic. In the fourth quarter, 0.73% of bank loans were noncurrent, according to data from the Federal Deposit Insurance Corp.
However, the industry has been bracing for an economic slowdown to hurt credit quality. This could translate into more opportunities for financial institutions to utilize Article 9 sales with commercial borrowers who fall behind on their payments.
“When I speak with bank special assets and credit officers, invariably they see distress on the horizon, particularly as they will be re-pricing assets in a rising interest rate environment and borrowers feel cash flow pressures,” said Robert Dinozzi, chief growth officer and partner at Second Wind Consultants, a firm that specializes in pre-packaging debtor consent to secured party sales. “While many have been describing their portfolios as fine or clean, there is also acknowledgement that pandemic aid has artificially propped up borrower balance sheet ratios.”
Article 9 reorganizations are completed outside of the court system, and involve the borrower agreeing to the first-position lender, in many cases a bank or credit union, separating its operating business from its assets.
The company’s assets that are secured as collateral by the lender are then sold to another party. This allows that entity to take on these assets without the debt. The process can be completed in as little as two weeks, meaning it is a faster resolution to a problem loan than other options, such as a bankruptcy, experts said.
Article 9 reorganizations can work for pretty much any business that has assets that could be sold, such as inventory, equipment or receivables. Real estate would not necessarily be part of the deal since foreclosures are handled under state law, but in some cases it could be.
In contrast, if a business files for bankruptcy, the proceedings become public — which sometimes both the bank and the business owner would rather avoid — and can sometimes take years to complete. A bankruptcy usually also means the lender has to shell out money for lawyers and court fees.
Only a small percentage of businesses have a successful discharge through bankruptcy, Dinozzi said. A Chapter 11 bankruptcy is meant for the failed business to be able to repay its creditors based on an agreed upon plan with court oversight. However, frequently these plans are challenged by creditors, and if the business continues to perform poorly, it usually can’t fully repay its debt.
“It’s fair to say that among restructuring and turnaround professionals, out of court processes are almost universally accepted as preferable to judicial ones in this segment of the market,” Dinozzi said.
To complete an Article 9 sale, in addition to needing the cooperation of the borrower, the senior secured lender also must notify all other lien holders about the assets being sold, the transaction price must be considered fair market value and the process must be conducted at arm’s length.
“You can’t have your Uncle John bailing you out for 50 cents on the dollar,” said Venable, the instructor for NACM.
Other entities with liens against the business with collateral that isn’t included in the sale, such as a vendor or a landlord, could fight the Article 9 sale if they are worried they won’t be fully repaid. But previous efforts to do this have been rebuffed by the courts, Venable said. In general, the requirements for an Article 9 sale are easy to meet, making challenges difficult, she added.
Gino Clark, a managing director and Los Angeles regional manager at White Oak Commercial Finance, a nonbank commercial lender, said that he likes that Article 9 sales can offer a second chance for some of these businesses. In some instances, the company’s owner may be hired by the buyer to oversee the operations.
“Ultimately it’s another tool,” Clark said. “You are looking for the best case alternatives for a restart and a new beginning. A normal bankruptcy process can be expensive. Article 9 sales are a fairly quick and inexpensive way for some of that value to move forward under a sale or new management.”
Deciding whether to pursue an Article 9 sale is very specific to each borrower and loan, experts said. For instance, these transactions are unlikely to work for a business that has “very complex debt structures, including junior lien holders and various amounts of trade debt,” said Gregory Felix, senior special assets officer at Synovus Financial, which is based in Columbus, Georgia. Article 9 sales also won’t work if the borrower is uncooperative or if the bank is likely to recover too little.
Usually to determine if this is a potential option, the bank will model what it might recuperate through a sale, Van Horn added.
“Does it find an Article 9 sale would be the best way to maximize the bank’s recovery? Then what does the company think? If the company isn’t agreeable then it’s a hard stop,” he added.
If both the company and the bank are agreeable to an Article 9 resolution, there could be negotiations between the two entities. For instance, if the borrower has a personal guarantee on the money owed to the bank, they may ask the lender to no longer pursue that if they go through with an Article 9, Van Horn said. The bank or credit union would need to take these types of requests into consideration.
“Every situation is unique and subject to the creativity of the parties involved,” said Felix of the $59.7 billion-asset Synovus. “Article 9 reorganizations are not for every situation; however, again, they can maximize recoveries when conditions allow for such a consideration.”