Bar News - May 23, 2008
Use of Bankruptcy Alternatives Rising
By: Peter Tamposi
Companies facing reorganization or liquidation have many options outside of the bankruptcy court. Although a Chapter 11 or Chapter 7 bankruptcy proceeding has historically been a refuge for troubled or distressed companies, bankruptcy has become increasingly expensive, time intensive, and heavy with professional fees, particularly in the smaller, less complex cases.
There are, however, alternatives to bankruptcy, which in some cases may be able to minimize some of the negatives of bankruptcy while still achieving the end result of an orderly reorganization or liquidation. There has been renewed interest in many of these alternatives in light of the broad changes imposed by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Not only are many out-of-court options more cost effective and faster to implement, but they may offer the company a better opportunity to preserve going-concern value that is frequently lost in a bankruptcy.
Many of these methods may also be used to acquire assets from distressed companies. In a series of articles, I will discuss various alternatives to bankruptcy, starting here with the Article 9 Sale. In later articles, I will discuss Assignments for the Benefit of Creditors and, finally, Receiverships.
ARTICLE 9 SALES AND FRIENDLY FORECLOSURES
Revised Article 9 of the Uniform Commercial Code (the "UCC" ) provides not only the rules for attaching and perfecting a security interest, but also the options available to a secured party upon default of the debtor with respect to the collateral. In New Hampshire, the UCC is codified at N.H. RSA 382-A:8-101 et seq. The rights of the secured party upon default are governed by § 9-609: "After default, a secured party: (1) may take possession of the collateral; and (2) without removal, may render equipment unusable and dispose of collateral on a debtor’s premises under Section 9-610." In turn, § 9-610 permits the secured party to sell, lease, license, or otherwise dispose of the collateral in its present condition so long as the disposition is "commercially reasonable." Additionally, the secured party may purchase the collateral at a public sale (i.e., at auction) or, if the collateral is of a kind that is customarily sold on a recognized market or is the subject of widely distributed standard price quotations (e.g., an automobile), the secured party may buy or sell the collateral through a private sale (Section 9-610(c)).
Once the collateral is sold via public auction or private, commercially reasonable sale, the proceeds of the sale are distributed to various parties pursuant to § 9-615. Receiving first priority to the proceeds are those who incurred the reasonable expenses of repossessing and preparing the collateral for sale (e.g., Sotheby’s gets paid first). Next, the first (and presumably foreclosing) lienholder, who may actually be the buyer of the collateral, takes its share of the proceeds. Thereafter, subordinate security interests, if any, are paid from the proceeds with any surplus going back to the debtor for the benefit of unsecured creditors. Depending on the type of collateral at issue, the obligor may be liable for the deficiency while the secured party is responsible for any surplus. If the foreclosing lien holder is not in the senior position, then the buyer will take the assets subject to that senior lien. Alternatively, the foreclosing party may elect to pay off the senior lien holder with the proceeds and thus sell the assets "free and clear." Obviously communication of the seller’s intent to prospective buyers with respect to this last point is critical.
Alternatively, a secured party may retain the collateral in complete or partial satisfaction of its obligations under § 9-620. That section provides that the secured party may, upon 20 days notice to the borrower and certain other parties identified in other provisions of the UCC, advise of its intention to retain the collateral. If there is no objection to the proposed retention the secured creditor may then retain the collateral as its own.
One distinct advantage of an Article 9 sale is that a secured party disposition pursuant to Article 9 can be done fairly expeditiously and with relatively less cost than that involved with sale under Section 363 of the Bankruptcy Code. Generally, the loan documents evidencing the secured claim will indicate when the sale is to occur. If proceeding with a public auction sale, the secured party should advertise widely and in specific trade journals for the borrower’s industry so as to reduce the likelihood of future attacks on the sale. In this case an auctioneer should also be retained in order to maximize the value of the assets at sale. These steps will necessarily increase the time and cost involved in ultimate disposition, however, even with these additional steps, the disposition can often be conducted in 30 to 90 days and the costs will generally be far less than those incurred in a bankruptcy filing.
Another advantage to a disposition outside of bankruptcy, including through Article 9, is the absence of judicial oversight. While a junior secured creditor may challenge the notification procedures used by the senior creditor, the final sale price, or other issues by bringing a lawsuit, the sale proceedings are otherwise conducted by private contract among the parties or alternatively at public auction. In either case the consummation of the sale does not require judicial approval. Similarly, the retention of the collateral in satisfaction of the debt allows the secured creditor to transfer ownership of the collateral from the debtor to the secured party (or its nominee) without much public notice and without any judicial oversight. It is not uncommon for such purchase and sale agreements to contain confidentiality clauses.
Exceptions to the General Rule
Disposition of assets through a secured party sale will generally allow conveyance of title to the asset free of junior liens and encumbrances. However, there are important exceptions to the general rule. First, later-filed security interest may actually have priority over the secured claim being foreclosed if it is a perfected purchase money security interest under §§ 9-103 and 9-324. Second, personal property on the premises of the borrower may belong to others and may not be subject to the lien of the foreclosing secured party. Third, certain property may be leased and therefore not subject to the lien of the foreclosing secured party. Additionally, various creditors, such as governmental authorities holding tax liens, may have rights to notice that must be complied with even if the lien is junior to that being foreclosed. For example, if the Internal Revenue Service (the "IRS") has filed a notice of federal tax lien that is junior to the security interest being foreclosed, then the foreclosing creditor must provide the IRS notification of the disposition at least 2 days before disposition is made and comply with the specific information requirements required by federal regulations. Of course one of the most attractive aspects of such a conveyance is that it allows a transfer of assets free and clear of all unsecured claims against the owner of the assets.
Possible attacks on secured creditor dispositions under Article 9 include: (1) attacks based on the fraudulent transfer theories of recovery, (2) conversion claims brought by other parties claiming and ownership interest in the collateral, (3) successor liability claims and (4) wrongful foreclosure claims. Each of these risks, however, can be significantly mitigated by appropriate planning and execution of the sale. Additionally, the proposed disposition may motivate creditors who are out of the money to file an involuntary bankruptcy petition against the company. Such a petition will prevent the sale from progressing unless and until the secured creditor receives relief from the automatic stay provisions of the Bankruptcy Code or meets some exception to the bankruptcy automatic stay. The commencement of a bankruptcy case may also subject the secured party to claims that their claims be subordinated or disallowed on theories of equitable subordination or recharacterization. While these kinds of claims may not be much of a concern in the case of an arm’s length lender, they are of greater concern in the case of "loan to own" schemes in which equity holders advance subsequent rounds to the borrower purportedly on a secured lending basis in order to exercise lending rights.
In the absence of an attack, however, the buyer of such collateral may essentially buy all of the assets of an operating company free and clear of any claims by most of the company’s creditors. While there are some risks, the potential reward of preserving going-concern value while leaving the right side of the balance sheet behind can outweigh the downside potential.
Peter Tamposi, a partner in Nixon Peabody’s Bankruptcy and Financial Restructuring Group, has represented creditors and debtors in all aspects of bankruptcy reorganization, litigation, restructuring, liquidation and work-outs.