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How Asset-Based Lenders Can Leverage Article 9 to Generate Business, Mitigate Loss

Article | October 21, 2021

As published in ABFJournal on October 15, 2021

By Robert DiNozzi, Kevin McGarry, Entela Semini and Aaron Todrin

Article 9 of the Uniform Commercial Code is a transactional tool that allows asset-based lenders to bolster business development and mitigate risk and/or loss.  It is a holistic and pragmatic out-of-court reorganization approach for extracting value from distressed businesses.

An Article 9 reorganization is a controlled short sale of business assets that maximizes value for all the parties involved in a default or insolvency scenario. This form of reorganization boils down to one principal: If a business shuts down, everyone loses. Through an Article 9 reorganization, the assets of a company are sold at forced liquidated values (which is what would otherwise happen anyway), the business operation flows through the sale without interruption and the unsecured and undersecured debts are left behind.

Everyone benefits. The business is preserved. The business owner has a path out when one did not previously exist. The creditors recoup maximum value. The buyer lowers their entrance cost. Jobs are preserved. Even the subordinate creditors benefit from the finality of the transaction so they can write the debt off their books and move on to their next deal.

Collectively, these benefits can represent a significant boon to the economy as a whole, creating value where there was previously just loss, liquidation and destruction.

Article 9 sales have become even more relevant today, as the COVID-19 pandemic has changed the competitive landscape permanently. As businesses are weaned off of government stimulus programs, they will have to adjust to the changed behaviors of their customers in order to retain and grow their revenues. The most resilient companies will adapt their business models to the new landscape by developing an e-commerce platform, among other things. Companies that have not or will not embrace change by investing in product development and the expansion of their sales channels will suffer the consequences and will need a plan to quickly transition their business to survive. Secured lenders have the opportunity to provide support through the Article 9 sale model, which can save business, jobs and general economic value while also mitigating loss at the same time.

“There are a lot of people that can benefit from knowing this. I think the awareness of this Article 9 opportunity should be known not just to borrowers, not just to lenders, not just to potential new lenders, but also trusted advisors — the CPAs, the lawyers, the turnaround professionals — that operate with this market,” Harvey Gross, president of HSG Services and executive director of IFA Northeast, says.

A Real-Life Example

A first position bank lender was about to initiate the liquidation process on the assets pledged as collateral for a defaulted business loan. Instead, the bank sold the assets through Article 9 to a brand-new operating entity owned by the original company’s CFO, CEO and COO, none of whom started with any ownership interests. The sale was financed by an asset-based lender and a factor, both of which leveraged the very same assets that were about to be liquidated. The original business owner was provided with an employment agreement, providing both value to the new company and a mechanism to resolve the deficiency balances on the failed company, which were personally guaranteed.

In the liquidation model, the business would have failed, the losses would have been maximized for the bank, jobs would have been lost and economic value would have been destroyed. In the Article 9 model, the business succeeded, the bank recouped maximum value because the assets were sold at a premium since they represented a going concern, the business owner preserved a stream of income, the new ownership group was rewarded with the acquisition opportunity and the new company lenders were granted an opportunity to fund a new business when they previously had to walk away.

What is Article 9?

Article 9 refers to the section of the Uniform Commercial Code that manages post default remedies for secured creditors. Specifically, it allows for a senior secured lender to liquidate assets outside of the formal judicial process. The UCC drafters acknowledged that legal procedure is often hostile, highly expensive, time consuming and ineffective. Their logic was that if the parties can work together to sell business assets, they will generate more money, as  deficiency balances will be lower for both the bank that incurred them and the business owner that guaranteed them.

Business owners that lack the ability change or adapt to the evolving needs of their customers may need a lifeline to protect their lenders, businesses, customers and employees. If the problems impacting the business are identified early enough and the Article 9 process is implemented immediately, restructuring a credit facility while maximizing the recovery against the assets could pave the way for a business to continue while mitigating the risk of loss.

Article 9 sales are not new. They have been around for decades but have historically been used for liquidation and nothing more. It has been generally assumed that since it is a liquidation tool, a business must be shut down in order to invoke it. This, however, is not true. A business can continue its operation throughout the entire process, thereby unlocking the greatest potential of this transaction structure. That’s what distinguishes an Article 9 reorganization from a classic Article 9 sale. Article 9 reorganizations can be used strategically to sell business assets while keeping a business alive. This can impact lenders in two ways:  First, Article 9 can be used reactively to clean up default portfolios more efficiently and with greater returns. Secondly, Article 9 can be used proactively by turning distressed businesses into lendable opportunities, and since the business can maintain its operations without interruption, there are impactful seller incentives available to glue the entire program together and align the interests of the parties despite financial distress and default.

Reactive Use – Mitigating Loss

For secured lenders, the use of an Article 9 sale to restructure or exit an underperforming transaction is ideal. One key benefit provides for maximization of the recovery value of a senior lender’s collateral in concert with the mitigation of the risk of loss and challenge to the disposition of the collateral that might arise from other creditors.

Lenders are obviously in the business of lending. While there are exceptions, more often than not, asset-based lenders aren’t in the business of selling used restaurant apparatuses, heavy equipment or retrofitted machinery; it takes an expert to be good at those things, which leaves asset-based lenders to fend for themselves when they have nonperforming credits. That typically means distressed situations end in public auctions, which is a surefire way to get the smallest return on assets pledged as collateral.

This doesn’t have to be the case. Article 9 allows secured creditors to avoid the legal foreclosure and liquidation process, as they can use the process to accomplish a better result without minimizing return, killing the business, evaporating jobs and losing general economic value that each and every business brings to the U.S.

The Article 9 sale is a more cost-effective option than a bankruptcy proceeding, as it affords lenders similar protections without the costs attendant to a bankruptcy. Also, the Article 9 process presents a more time-efficient option to the wind down, which mitigates the deterioration of collateral values that can result from a long and sometimes arduous bankruptcy proceeding, For a debtor, the benefits of the Article 9 sale include an expeditious and cost effective wind-down or restructure of the business that significantly reduces their personal obligations to the creditors, assuming there was no fraud or other spurious activity that contributed to the demise of the business. In addition, it allows debtors to provide employment opportunities to shareholders and key employees.

An added benefit for lenders is the creation of financing opportunities as acquirors look for liquidity to finance the purchase price of the assets. Incumbent lender(s) of the seller and purchaser will have the opportunity to provide financing for the transaction, contributing to portfolio growth and revenue generation.

When evaluating the risks and outcomes and determining which course to take, an Article 9 sale is the most effective option in many aspects. It is quick and inexpensive, fewer parties are involved and secured lenders have more control, which is the opposite of what a liquidation scenario brings to the table. Such a liquidation can turn out to be expensive and a longer process with many unknowns, so an Article 9 sale is advantageous not only because it may yield more than what the liquidation could, but it also removes the burden of having to liquidate from the lender perspective. 

Proactive Use – Bolstering Business Development

By using Article 9 proactively, lenders can transform deals they would pass on into deals they can complete.

Once assets are sold through Article 9, all subordinate liens and encumbrances are stripped off the assets. The business’ operation, however, continues to run without interruption throughout the entire process. This means that the Article 9 purchaser can be lent to with clean, unencumbered, going concern assets — the very same assets that were previously unlendable.

“This tool gives flexibility to secured lenders to fund an opportunity without just saying ‘no’ because the picture looks bleak,” Gross says.

Article 9 sales have almost the identical effect of a 363 sale but without the cost, unpredictability, burden and risk of a bankruptcy filing. It also has almost the identical effect of an assignment for the benefit of creditors (ABC), but it doesn’t require consent of all parties, least of all the subordinate un/under-secured creditors, although they wouldn’t have a say in a liquidation proceeding anyway. The Article 9 sale or reorganization, instead, is a tool that leverages reality — what would otherwise happen — to provide maximum value to the parties that legally derive such benefit while keeping a business alive and therefore creating lendable opportunities in place of distress and loss.

Leveraging an Article 9 structure to either support existing portfolio companies that are looking for strategic growth opportunities or restructure a distressed portfolio company that has been driven to the brink of bankruptcy is a preferred and viable alternative to bankruptcy. Preserving a company’s brand equity, customer relationships and revenues while at the same time extinguishing debt through an Article 9 sale can help secured lenders retain clients, protect revenues and develop new relationships that come with the added benefit of risk mitigation. Rather than run from a deteriorating situation, an Article 9 sale creates a fresh start opportunity that protects a lender’s loan and perpetuates the relationship.

“In these situations, a reorganization would be of enormous benefit and help because we’ve absolutely had to turn down deals when we could not take first position on a lien,” Nancy Kalman, senior business development officer at United Capital Funding, says. “We’d be able to get a lot more deals done.”

The COVID-19 Impact

We are far from the best of times. The future remains uncertain, but the world at large — businesses and lenders in particular — are beginning to see the light of “normal” at the end of the pandemic tunnel. What impact is this going to have and what are we going to do about it?

In the coming months, several key themes will arise and questions will be answered. When will loan markets clear such that demand comes back into equilibrium with supply? Will there ever be a wave of defaults, or will it be a slow and trickling rising of the sea level? This piece was not written to surmise what those answers might be. Instead, this piece aims simply to acknowledge that defaults are coming, and knowing how to deal with them efficiently while avoiding litigation to the extent possible is in the best interest of every party involved in a business loan default.

So be aware and know your options. Article 9 is not a one-size-fits-all situation. It’s just a tool in the toolbox, but it can’t be put to use if you don’t know it’s there. We might not be feeling it just yet, and the indicators might be suppressing the reality, but there’s a huge amount of distress out there, as the entire world is feeling it. Yet, in distress lies opportunity. If you have the correct tools to help navigate these uncertain times, you have an opportunity to make a real difference and truly effect change. Article 9 is not a new tool, but it’s certainly one to understand to give the best chance at pure and proper financial recoveries.

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