[author: Ramesh Dhanaraj]

Since the financial crisis, sales under Section 363 of the Bankruptcy Code have provided an increasingly popular way for secured creditors of distressed businesses to recover their loans.  However, despite the advantages of Section 363 sales, the significant expense and time required to conduct a Bankruptcy sale has caused secured creditors to pursue less comprehensive solutions.  One alternative for recouping value from a troubled loan is an Article 9 foreclosure sale under the Uniform Commercial Code (UCC).

Article 9 (Part 6) of the UCC provides certain statutory remedies to all secured lenders, whether or not such remedies are expressly provided by the security agreement entered into by the lender and the borrower in a lending transaction.  If a borrower defaults under its loan agreement, Article 9 entitles a secured lender to pursue certain rights and remedies with respect to the lender’s collateral (for which a lien may be perfected under Article 9) as set forth in the parties’ security agreement and in Article 9 itself.

However, unlike a Section 363 sale where a Bankruptcy Court approves the process and the sale of a debtor’s assets itself, the UCC provides foreclosing creditors with procedural guidelines for selling collateral assets under Article 9.  This leaves an opening for others to attack the sale process after it is completed.

Such an attack occurred in the recent case of Edgewater Growth Capital v HIG Capital in Delaware.  In Edgewater, a private equity fund, Edgewater Growth Capital (“Edgewater”), acquired a company called Pendum which was in the business of servicing automatic teller machines.  Pendum became highly leveraged due to the significant debt financing that was required to consummate the acquisition.  Soon after Edgewater’s acquisition, Pendum began experiencing serious financial difficulty and became in default under its credit agreement with its lenders.  After numerous amendments to Pendum’s credit agreement were allowed, HIG Capital, another investment fund, purchased a majority of Pendum’s senior debt at a discount.  When Pendum requested yet another amendment from its creditors, its ninth in only about a year and a half, HIG agreed to approve it only under the condition that Pendum’s Edgewater-appointed board members resign from the board.  Consequently, Edgewater’s board members resigned and were replaced with a new board consisting of experienced restructuring consultants.  HIG then negotiated an agreement with the new board under which Pendum’s assets would be sold under Article 9 (the “Foreclosure Sale Agreement”).  Under this Foreclosure Sale Agreement, Pendum’s new board would first be allowed 55 days to attempt to sell the company independently outside of the Article 9 foreclosure sale context.  If no buyer was found during this so called “market check”, it was agreed that HIG would immediately commence an Article 9 foreclosure sale of Pendum’s assets.  As part of the Foreclosure Sale Agreement, HIG agreed to fund both the costs of finding a buyer and the operations of Pendum during the market check.  It also provided the board with a fiduciary “out” which allowed the board to continue to seek potential buyers for the business even after the allotted time for the market check expired.

Pendum conducted an extensive effort to sell itself which included hiring an investment bank and contacting 67 potential bidders.  Despite its considerable efforts, Pendum’s board was unable to secure a buyer for the business during the allotted 55 days.  Shortly thereafter HIG moved forward with the foreclosure sale.  HIG contacted 60 potential bidders and provided public notice of the sale by running advertisements in the Wall Street Journal.  In the end, no outside buyers arose on the day of Pendum’s auction and an affiliate of HIG purchased the company’s assets.  Edgewater then brought suit against HIG in the Delaware Court of Chancery contending that HIG’s acquisition of Pendum was not commercially reasonable under the UCC and was a prohibited private sale.

Edgewater alleged, among other claims, that HIG failed to conduct Pendum’s foreclosure sale in a commercially reasonable manner because the Foreclosure Sale Agreement discouraged competition by allotting too short a time period for properly marketing and selling the company.  The Edgewater Court disagreed.  It found that “commercial reasonableness” for Article 9 sales must be analyzed through the lens of the type of collateral being sold.  The court reasoned that, in the case of a distressed business, the analysis should turn on whether the secured party sold the collateral in conformity with the practices of a seller of “distressed entities”.  It went on to point out that any commercially reasonable process must take into account the “stark reality of the company’s economic facts, not based on the assumption that the foreclosing party must prop up [a] failing entity for the lengthy period that a healthy going concern could use to test the market.”  Specific factors that supported HIG’s actions and the timing as being commercially reasonable were that HIG (i) financed the company’s operations and independent efforts to find a buyer prior to commencement of the foreclosure sale, (ii) provided the board with a fiduciary “out” to continue to seek potential buyers even after the market check deadline, and (iii) allowed for a robust sale process which ultimately provided 83 days for marketing a highly distressed company and included discussions with over 60 potential bidders. 

Additionally, Edgewater claimed that HIG’s sale of Pendum’s assets was private, and thus improper under Article 9, since Pendum’s assets were marketed and sold under agreements privately negotiated by Pendum’s board and HIG.  The Edgewater Court clearly points out that under Article 9 a secured party may purchase its own collateral, but it must do so at a “public” disposition not a “private” disposition.  A public sale under the UCC is one in which the public has had a meaningful opportunity for competitive bidding.  The Court disagreed with Edgewater’s argument and found that HIG’s efforts to include Pendum’s board in the sales process, which HIG took even though it had no contractual obligation to do so, was a manifestly positive one.  In dismissing Edgewater’s contention, the court asserts that if it were to deem a sale “private” whenever a borrower negotiates contractual concessions from a foreclosing party in order to give the borrower a greater chance to find a more favorable buyer, it would only be creating counterproductive incentives for secured creditors to exercise their rights in a way that would be adverse to borrowers.  

The takeaway from Edgewater is that in cases where secured creditors are faced with the so-called melting ice cube scenario, the extent to which a borrower’s business is deteriorating may be balanced against the robustness of the foreclosure sale process making an Article 9 sale an attractive option for creditors when time is of the essence.