Eliminating Distress: UCC Article 9 Means Business for Factors

Robert DiNozzi of Second Wind Consultants outlines how factors can use a UCC Article 9 sale to create new factoring relationships and/or preserve current ones.

BY ROBERT DINOZZI

For factors, business distress often means lost opportunity, but that doesn’t have to be the case.  Whether it’s an overleveraged, unfinanceable applicant or a current client whose operation finds itself on the brink of insolvency, there is a tool to help factors create and keep more business.

Article 9 of the Uniform Commercial Code (UCC) provides for a specific form of asset sale that helps transition a business’ assets (and therefore, its operations) into a new legal entity. Debt and distress are left behind with the insolvent entity as operations pass uninterrupted into the new entity, under new ownership. By result, the underlying value of the business is extracted and preserved.

“This tool gives flexibility to secured lenders to fund an opportunity without just saying ‘no’ because the picture looks bleak,” Harvey Gross president of HSG Services and executive director of IFA Northeast, says.

Removing Distress with Article 9

The UCC consists of a standardized set of business laws that regulate commercial business transactions and financial contracts. It has been adopted by all 50 states (although with some variations). The code has nine separate articles (11 if you count 2A and 4A), each of which deals with separate aspects of banking and private, secured loans. The UCC better enables lenders to loan money secured by the borrower’s personal property — basically any class of property other than real estate. 

Under Article 9 of the UCC, specifically Section 610 (the entirety of Part 6 of Section 9 addresses default scenarios), if a debtor defaults on its loan obligation, the creditor has the option to repossess the secured property and sell it to a third party, either publicly or privately, in a commercially reasonable manner.

While most professionals are familiar with UCC Article 9 as a tool for liquidating assets after a business has shut down, it also can be leveraged as a business preservation tool. Rather than merely disposing of pledged collateral after the fact, the assets of an operational business can be sold ‘in use’ with defaulting borrower consent.

In this way, the Article 9 transaction can be used as a strategic asset short sale that provides for the due course of recovery on a defaulted business but with the benefit of passing the operation into a new purchasing entity. Debt is left behind in the previous business entity to be resolved as it would in any case, while the operation remains uninterrupted. In many instances, a factor can finance the asset sale itself through the A/R.

“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,” Gross says.

Although an effective and relatively easy tool, the Article 9 sale process still must follow certain protocols. The sale requires seller consent and cooperative repossession of collateral in a manner that does not breach the peace. Compliance with a 10-day notice period for disposition of collateral is also required under Article 9. Additionally, adequate consideration is required such that a fair market, forced liquidation valuation is recovered by way of a commercially reasonable public or private sale. FMV should be established by two appraisals: one by the senior lender and one by the purchaser.

By statute, with seller consent, compliance with noticing requirements and adequate consideration, all subordinate liens and liabilities are removed from the assets, which pass unencumbered into the new entity, and this new entity can be financed by the factor.

A Solution for Owners and Factors

The reasons for a borrower to consent to the Article 9 sale of in-use assets (and thus, to giving up ownership of the business) can be understood in a default context. A distressed owner can avoid a bankruptcy while also avoiding the destruction of the business and its jobs. And because they can earn income from the new company in the form of an employment agreement or consultancy, they maintain a viable path to resolving personal guaranties. Additionally, after saving for and settling PGs on loans made to the original company, owners are eligible to earn re-entry into the new business.

By offering a solution to the defaulting borrower’s circumstance without bankruptcy, this path incentivizes the borrower to work cooperatively with the senior lender in conducting the Article 9 sale.

Such cooperation can circumvent litigation while providing for the consent required by Article 9 and ensuring there is never a need for self-help repossession.

The Article 9 sale is typically complete in about 45 to 60 days, offering a lifeline to a distressed business and a clean balance sheet for factors. Thus, factors can capitalize on new opportunities and preserve relationships that would otherwise fail.

Encumbered A/R

Factors inevitably encounter businesses overleveraged with debt, including traditional bank debt, subordinate debt, vendor debt, lines of credit, or even merchant cash advances (MCAs). The conundrum is that these businesses often have attractive A/R that isn’t transactable because the receivables these businesses want to factor are already encumbered by general blanket liens or MCAs.

In most cases, a factor simply walks away. In other cases, a factor will attempt a complex global settlement of a lengthy debt schedule in order to assume first position if the long-term opportunity merits this strategy.

In situations when the factor would otherwise turn away a funding applicant, UCC Article 9 can remove MCAs and other subordinate debt from the asset base, allowing a factor to take a senior lien.

“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 … we’d be able to get a lot more deals done,” Nancy Kalman, senior business development officer at United Capital Funding, says.

Protecting Against the MCA Threat

In order to prevent insolvency and the loss of a client relationship, factors can use the Article 9 sale to eliminate MCAs and other subordinate debt from a client’s operation without buyouts or negotiations.

In the alternative lending environment, lenders and borrowers depend on a well-functioning ecosystem to deploy capital, create value and renew the cycle. This ecosystem is characterized by established norms of order and transparency that benefit all parties by making efficient transactions possible and sustainable.

MCAs disrupt this symbiosis. MCA companies do not look at debt schedules, negotiate intercreditor agreements or identify particular assets to lend against, and yet they still lend money from a subordinate position and wreak havoc for businesses and lenders.

MCAs have direct access to business operating accounts, so the priority list or debt schedule is completely irrelevant. This also renders intercreditor agreements completely unnecessary for MCAs because they can access operating accounts without these agreements, and senior lenders would never approve these financial instruments in the first instance.

MCAs also interfere with specific collateral value. At the first sign of financial struggle, MCAs send a UCC 9-406 letter to their borrowers’ client base demanding that all monies owed to the borrower be redirected to the MCA. MCA’s will even send these notices of assignment to the borrower’s factoring company and senior creditor. While MCAs, by definition, are a purchase of general future revenue, MCA providers go after specific receivables whether or not they were already pledged or factored. 9-406 Notices are not issued by a court, a judge, a clerk, or, oftentimes, even a lawyer, yet they are still surprisingly effective. Recipients routinely adhere to their direction, or freeze and sit on the money. Both actions can damage a business and completely disrupt lending relationships with senior secured lenders.

For factors, the Article 9 transaction can protect the factoring relationship and collateral from the operational threat of MCA withdrawal or operating account sweeps. Through the Article 9 sale, the MCA threat is removed, while the entire asset base is unencumbered in the new entity, resulting in a clean slate for the business and the lender.

The Bottom Line

Protecting factoring relationships from insolvency is possible without complex negotiations or buyouts. The solution made possible through UCC Article 9 can protect business operations and offer a solution for a distressed owner while ensuring an ongoing factoring relationship with a healthier company moving forward.

From a business development vantage point, a factor can re-evaluate opportunities rather than disqualifying them based on sub-debt. Chances are, if a factor can’t help a business, it’s last chance at being capitalized has passed. In those situations, UCC Article 9 may represent an alignment between the best interest of the business and a new funding opportunity for the factor.

Whether it’s an overleveraged applicant or an at-risk client, UCC Article 9 offers an expedient option for removing distress from a business.

Robert DiNozzi is the director of growth and business alliances at Second Wind Consultants.