By Mark Claster and Jonathan Killion, Carl Marks Advisors

It is an unfortunate reality that, as the economic repercussions of the COVID-19 pandemic continue to be felt, an increasing number of businesses will face financial and operational distress. For many of these businesses, bankruptcy may be an appropriate or necessary path to restructure their balance sheets. However, it is not the only option and lenders must keep that in mind as companies increasingly default under their credit agreements.

Bankruptcy can be an extremely useful tool for restructuring a company, but can also be expensive, lengthy and frustrating. That’s why more lenders are considering a Strict Foreclosure process executed under Article 9 of the Uniform Commercial Code. This strategy can offer many of the same benefits as a bankruptcy filing while requiring less time and fewer financial resources. In order to properly assess the benefits and risks of this approach, lenders must have a firm grasp on what it entails, when best to use it, as well as how to manage people throughout the process.

Strict Foreclosure: What It Is and When to Use It

In the Strict Foreclosure process, a business’s assets are not sold directly to a third-party buyer – a key differentiation from a bankruptcy. Instead, a two-step sale allows lenders to foreclose on the assets of a business and then later sell it to a third party. Through this process, lenders can reshape a business through the creation of this new entity, acquiring assets and assuming only those liabilities that are helpful to the new entity’s go-forward strategy. This allows lenders to recoup their initial loss through equity ownership in a reorganized business without going through the bankruptcy process.

Since the initial buyer would be the lenders, there are two criteria under which an Article 9 Strict Foreclosure process is a viable option:

1. the relative values are such that only the secured lender will obtain a recovery from the sale of the business.
2. the other constituents can generally agree on the value of the business.

If these conditions are met, neither the Board of Directors nor any other creditor would have any financial incentive to object to a Strict Foreclosure since a sale of the business would provide no additional recovery for the borrower’s other constituents. It’s important to note that since the pandemic has, in many cases, made projecting revenues extremely difficult, the agreement on valuation by stakeholders may be a more difficult task than anticipated.

Generally, a Strict Foreclosure process can be a good alternative to bankruptcy if the protections afforded by the Bankruptcy Code are considered to be less valuable to the lenders than the cost of the bankruptcy itself. However, when the value of the business either exceeds or is relatively close to the amount of the secured debt, then a Strict Foreclosure is far less likely to offer  a viable path forward. The Board, in exercising its fiduciary duties, would likely consider other restructuring alternatives, including filing for bankruptcy protection.

The viability of a Strict Foreclosure process may also depend on the company’s industry sector. Businesses with multiple locations and with many rent and vendor contracts, such as restaurant  and retail companies,  would face significant challenges with this process  since consent is needed from all parties to make a transfer.

Managing People During a Strict Foreclosure

One aspect of a Strict Foreclosure process that is often overlooked, but heavily impacts its potential success is people and incentives. Not only must lenders replace the company’s Board of Directors with independent directors early in the process, they must carefully consider how to retain and motivate existing company management in order to increase the value of the newly created entity and position the business for a successful eventual sale.

One way to do this is with a properly structured Management Incentive Plan (MIP) which can include stay bonuses, equity grants, profit interests and change-of control triggers. Developing an MIP should take the following factors into account:

1. Meeting the Needs of Management – While an MIP must be approved by the Board of Directors, lenders should solicit feedback from management to understand what they want and need. Not only will this guide the structure, it will let management know they are being looked after and improve working relationships between all parties.
2. Prior Compensation – Lenders need to understand the existing incentive structures through a detailed review of any previous or existing bonus plans and through conversations with management. In many instances, management may have been either undercompensated or not received bonuses or raises. Lenders should be aware of any concerns so they can propose a better approach moving forward.
3. Proposed Capital Structure – When creating an MIP, it’s important to understand and take account of the company’s current and proposed capital structure. If there is less debt in the proposed structure than in the current one, there will be more equity proceeds available from the value of the enterprise at exit.
4. Financial Forecast – To ensure that the MIP is financially viable, you need a careful review of any financial forecasts to confirm that the plan can be supported by projected cashflows and funding.
5. Potential Exit –  A Strict Foreclosure process is often part of a two-step sale of the business over three to five years. Therefore, it’s critical to take an exit valuation into account in a MIP, and to include equity stakes large enough to properly incentivize management.

The COVID-19 pandemic has forced many businesses that would not have considered bankruptcy or restructuring to explore these options. Although Strict Foreclosure under Article 9 is a complex process that requires consent and agreement from both the borrower and lenders, it should be considered by traditional lenders and specialty finance providers as an alternative to the expensive and lengthy bankruptcy process. Properly managed, the process can be much less costly and be completed in as little as 45 days whereas a Chapter 11 filing could take a lot longer.

Mark Claster is a Managing Partner at Carl Marks Advisors and can be reached at mclaster@carlmarks.com.

Jonathan Killion is a Managing Director at Carl Marks Advisors and can be reached at jkillion@carlmarks.com.