In this post you’ll learn how debt relief under Article 9 is a cooperative process–benefits both business owners and creditors.
Business debt relief under UCC Article 9 involves an out-of-court, cooperative restructuring that preserves a business operation in a new, debt-free operating entity, as reported by Bloomberg Businessweek in August 2020.
Specifically, an Article 9 “reorganization” involves an asset sale, conducted cooperatively between a business owner and the bank, to give the business a clean balance sheet in a new legal entity. Given the alternative of closure and liquidation, debt relief under Article 9 benefits creditors, who will recover more when a business is preserved and relaunched than they would if it were liquidated. This is why debt relief under Article 9 is a cooperative process.
Context is essential to understand why the bank would (perhaps counter-intuitively) cooperate in a process that removes debt from a business. It’s important to remember that when a bank liquidates a business, this is the last resort. Not only do banks recover very little from auctioning off used business assets, but they must spend time and money to do so. The recovery value is nominal and uncertain.
Furthermore, it is very often the case that a deficiency balance will remain after liquidation. There is commonly a personal guaranty on any remaining deficiency, leaving former business owners forced to meet the liability personally or file an individual Chapter 7 bankruptcy. When a business is liquidated, creditors left with personal guaranties benefit very little when their guarantor has become personally insolvent. These defaulted loans are often “charged off” to a third-party debt collector, with creditors recovering pennies on the dollar.
The business operation is transferred through the cooperative Article 9 debt-relief process into a new legal, debt-free entity. Business debt remains behind in the previous (and insolvent) operating entity. As a result, the business is separated from the debt; the distress threatens its viability. This gives the company a real second chance and allows creditors to recover more than they would in the alternative scenario of closure and liquidation
Debt relief under UCC Article 9 might be considered a compromise. By removing debt from the business, the bank’s guarantors will continue to earn. That way, personal guaranties on loans removed from the business can be settled affordable and over what the bank would recover if the company failed.
Is This Bankruptcy? No.
Business debt relief under UCC Article 9 can be understood as an alternative to bankruptcy. Unlike a bankruptcy filing, the Article 9 process is out-of-court, does not require lawyers, and is executed as a private negotiation between borrower and lender. A little more context is needed here as well.
In a Chapter 11 bankruptcy filing, the intended outcome is the preservation of the business and full repayment to all secured creditors. The business submits a plan to repay its obligations over five years. The system was designed to give an overleveraged company a second chance while also facilitating recovery for creditors, but there is a glaring problem: It doesn’t work very well. The vast majority of small and medium-sized businesses stand very little chance of successfully completing a Chapter 11 plan. There are many reasons for this, including the expense, time, and loss of control over operations.
Approximately 90 percent of small and medium-sized businesses (SMBs) who attempt a Chapter 11 plan will fail, being kicked out and often converted to a Chapter 7 liquidation. From the bank’s point of view, this is the worst of outcomes. Not only are they back in the liquidation scenario, but they had to incur even more expense and time in the process. So when a business owner attempts a Chapter 11 plan as a last resort, the bank is forced to invest further time and money despite the considerable cost and low likelihood of success.
A Cooperative Solution Preserves the Business: Debt Relief Under Article 9
With borrower consent (from the business owner), the bank can elect not to liquidate at auction but instead to ‘sell’ the assets into a new operating entity. Typically, this restructuring will involve an ‘asset-based loan’ to facilitate the purchase of the business assets from the bank.
In the process, all other debt is removed from the business operation and given a clean balance sheet. Only the business assets and operations transfer into the new operating entity.
Simply put, think of it as the bank selling the assets to the new entity rather than at auction. When assets are liquidated at auction, the business is ended. The business is preserved when assets are sold into a new operating entity. A preserved company can keep producing value, which is how even creditors benefit from debt relief under UCC Article 9.
Personally guaranteed debts may remain in the old operating entity, along with other unsecured debts, vendor debts, etc. But by preserving the guarantor’s business, and their ability to earn from it, all creditors can recover more through reasonable settlements than they would if the company was liquidated. Beyond that, there is an obvious benefit to vendors who preserve relationships with the business and employees who keep their jobs.
Debt relief under UCC Article 9 can be understood as a unified solution designed to preserve a business and benefit all parties over the alternative of closure and liquidation. UCC Article 9 reorganizations arose as an out-of-court alternative to bankruptcy, whereas bankruptcy has often failed both creditors and owners. By providing a suitable solution, Article 9 debt relief can ensure the survival and renewal of a business while also ensuring creditors recover more than they would in liquidation.
Any questions? Add them below!
“Note: The post above is for informational purposes only. Before taking action, individuals should seek professional guidance, including legal, tax, and financial advice.”