This article was published as part of the July 2009 Sub-Debt Report . A slightly revised version was published in Law360 on August 11, 2009.
The rate of loan defaults has been on the rise, and given the current state of the economy, this trend is likely to continue. Doubtful loans may only get worse, raising that subject that lenders never want to hear, much less discuss: Foreclosure. Senior lenders will almost certainly have a first priority lien on all of the general assets of the borrower, and to the extent a junior lender is even permitted a second priority lien on these assets, it will be subordinate to the senior lender’s lien pursuant to a subordination agreement. So, why should a junior lender even care about foreclosure remedies?
There are several scenarios under which the junior lender may be the lender who exercises foreclosure remedies. First, the senior lender’s debt may have been extinguished, thereby removing the senior lender’s lien. Second, the subordination agreement may permit the junior lender to exercise available remedies in situations where the senior lender elects not to exercise its remedies. This can occur when the senior lender is over-collateralized on its loan and therefore does not feel compelled to foreclose. Moreover, the senior lender often takes only a security interest in the general assets of the company, and not in the equity interests held by the owners of the company, thereby leaving the junior lender with the opportunity to take a first priority security interest in the equity interests. Accordingly, the junior lender is more likely than a senior lender to be foreclosing upon the equity interests of the company.
By understanding the procedures that each foreclosure remedy requires, a junior lender is better positioned to protect its subordinated interests. For instance, as discussed below, a junior lender can object for any or no reason to the senior’s use of strict foreclosure.
Revised Article 9 (“Article 9”) of the Uniform Commercial Code (the “UCC”) governs the remedies available to a creditor that wishes to foreclose upon collateral securing a debt, including a pledge of equity interests. Part 6 of Article 9 generally provides for three methods of foreclosure: (1) a private sale of the collateral; (2) a public sale of the collateral; and (3) strict foreclosure on the collateral ( i.e., retaining the collateral in full or partial satisfaction of the debt).[1] Each disposition of the collateral must be conducted in a “commercially reasonable” manner[2], and each remedy may be utilized to foreclose upon equity interests. For the reasons discussed below, however, if the creditor wishes to actually acquire the equity interests, most likely it can only do so by conducting a public sale or strictly foreclosing upon the interests.
Section 9-610(b) of Article 9 provides that a creditor can foreclose upon collateral by selling the collateral at a public sale.[3] Before conducting any such sale, the secured party must provide reasonable notification of the foreclosure sale (at least 10 days), including the “time and place of [the] public disposition,” to the (1) debtor, (2) secondary obligors and (3) other persons of which the secured party is deemed to have notice of such person’s interest (including a security interest) (collectively, the “Notified Persons”).[4] To identify any persons with security interests in the collateral, the secured party must order a lien search between twenty to thirty days prior to the proposed sale.[5]
As opposed to a private sale, “a ‘public disposition’ is one at which the price is determined after the public has had a meaningful opportunity for competitive bidding. ‘Meaningful opportunity’ is meant to imply that some form of advertisement or public notice must precede the sale (or other disposition) and that the public must have access to the sale (disposition).”[6]
Advertising is the essential element in creating the “meaningful opportunity for bidding.” Serious thought should be given as to which type of publication in which to advertise the sale of the collateral so as to maximize public participation. Under Article 9, publication in a newspaper of general circulation may not be sufficient. For instance, publication in a local widely-circulated newspaper may be appropriate for the sale of equity interests in an entity that owns a small to moderate amount of regional real estate. However, publication in a nationally-circulated newspaper, such as the Wall Street Journal, may be warranted for entities that own large tracts of property or property that is dispersed over several different states. Advertisement should be considered in publications in geographic areas where there are large concentrations of potential purchasers, even if their physical location is different than that of the debtor whose equity interests are to be sold. Advertisement in trade journals may also be warranted if there are journals applicable to the type of property or business operated by the entity.
After the sale has been completed, the secured party may apply the proceeds from the sale to its debt and the expenses it incurred in conducting the sale.[7] If there is any surplus, the secured party must pay over any remaining proceeds to any subordinated secured creditor who made a demand for payment prior to the distribution of the proceeds from the sale; the remaining excess, if any, goes to the debtor.[8] Accordingly, a subordinated creditor should immediately send a demand notice to the foreclosing creditor upon receipt of the notice of the sale. If, on the other hand, there is a deficiency and the debt was recourse, the secured creditor may proceed against the debtor for the amount of the deficiency.[9] This deficiency claim, however, is likely to be of little or no value, which highlights the need for personal or other guaranties to secure the loan as well.
There are some specific securities law concerns related to the public sale of equity interests of which secured parties should be aware. Both federal and state securities laws prohibit the sale of securities without registration unless the sale falls within an exemption to these securities laws. The most common of these exemptions is a “private placement” to “accredited investors”.[10] While the public sale requirements discussed above could cause a violation of these securities laws, “[a] disposition that qualifies for a ‘private placement’ exemption [to the registration requirements of the securities laws] nevertheless may constitute a ‘public’ disposition within the meaning of [Article 9].”[11] In addition, the “commercially reasonable” requirements of Article 9 do not prevent a foreclosure sale from complying with the registration requirements of the security laws.[12] Thus, a public sale, and the associated advertising, can be limited to only accredited investors to comply with the securities laws.
Section 9-610(b) of Article 9 also provides that a creditor can foreclose upon collateral by selling the collateral at a private sale.[13] Indeed, Article 9 encourages such a disposition because private dispositions “frequently result in higher realization on collateral for all concerned.”[14]
Similar to a public sale, a private sale also requires reasonable notification.[15] Rather than providing notice of the date on which the sale is to occur, however, a private sale notice only requires notification of the “time after which” such a sale is to occur.[16] The treatment of any excess or deficiency after the sale is identical to that in a public sale.[17]
The major advantage of a private sale is the elimination of the time and expense involved with advertising a public sale. Unfortunately, the foreclosing secured party cannot participate as a potential buyer in a private sale of collateral unless “the collateral is of a kind that is customarily sold on a recognized market or the subject of widely distributed standard priced quotations.”[18] These exceptions are narrow and generally only apply to fungible commodity-type assets with standard (i.e., non-negotiable) market prices and equity interests traded on a national stock exchange.[19] Thus, only rarely will a foreclosing secured party be able to acquire assets at a private sale, and almost never will it be able to acquire equity interests at such a sale.
Unlike former Article 9, which only permitted strict foreclosure with respect to tangible personal property in the possession of a secured party, Section 9-620(a) of Article 9 now expressly permits acceptance "in full or partial satisfaction of the obligation" with respect to any type of collateral, whether tangible or intangible and whether or not in the secured party’s possession.[20] Accordingly, a secured party can strictly foreclose upon equity interests taken as collateral in either partial or full satisfaction of a debt.
The secured party must follow several procedural steps before initiating a strict foreclosure. It must provide notice of the proposed strict foreclose to the Notified Persons, including whether such strict foreclosure will be in partial or full satisfaction of the debt.[21] If any Notified Person, including any junior lender, objects to the foreclosure, for any reason or no reason, within twenty days after the proposal was sent by the foreclosing party, the secured party cannot proceed with the proposed strict foreclosure.[22] Moreover, if the secured party proposes to accept the collateral only in partial satisfaction of the debt or places conditions on the acceptance of the collateral as satisfaction in full of the debt (other than a condition that collateral not in possession of the secured party be preserved or maintained), the debtor must consent to the proposed strict foreclosure, and can only do so after the default has occurred.[23]
If there are no objections to the proposed strict foreclosure, the secured party takes title to the collateral, forgives either the full amount of debt or that portion of the debt on which the parties agreed, and all subordinate security interests and liens are discharged.[24] So, once a senior lender has strictly foreclosed upon the assets of a company in which a junior lender had a subordinate security interest, those subordinate interests are extinguished and, in general, the junior lender will be in no better condition than the company’s general creditors.[25] The foreclosure proposal is binding: “The secured party’s agreement to accept collateral is self-executing and cannot be breached. The secured party is bound by its agreement to accept collateral and by any proposal to which the debtor consents.”[26] In the instance of a partial satisfaction, the secured party retains a claim for the portion of the unpaid debt, but again, this claim is likely to have little to no value.[27]
A subordinated creditor should always object to a senior creditor’s strict foreclosure if the value of the assets being foreclosed upon is higher than the debt owed to the foreclosing secured creditor; otherwise, the foreclosing party will take possession of collateral that could have been used to satisfy the debt owed to the subordinated creditor. However, in most cases, the collateral is worth less than the outstanding debt owed to the foreclosing party. In such cases, the subordinated creditors have little incentive to object to a strict foreclosure in full satisfaction of the debt because a public or private sale (assuming at or below market value) would similarly result in all of the proceeds of the sale being used to pay the debt owed to the foreclosing senior creditor. Neither the debtor nor any secondary obligor should object to a strict foreclosure in full satisfaction of the debt as their obligations under the debt would be extinguished.
More negotiations are likely to be required in the case of a strict foreclosure in partial satisfaction of the debt, assuming the collateral is worth less than the debt. The debtor and secondary obligors would likely argue that the value to be assigned to the collateral should be higher than the value assigned by the secured party because they would remain liable for the balance. Subordinated creditors should likely have little objection because all of the proceeds from any sale would have been used to satisfy the debt owed to the foreclosing senior creditor anyway. However, if the value assigned to the collateral is less than the collateral’s market value, the deficiency would reduce the pool of funds available to pay the subordinated creditor and other unsecured creditors. In such an instance, it would not be unreasonable for a subordinated creditor to object.
There are also several advantages to strict foreclosure over public and private sales. First, there is time and expense in gathering assets, other than equity interests, that can be avoided by taking title to the assets. Second, it eliminates the advertising costs attendant with a public sale. Lastly, the process itself can be effected quite efficiently and in a relatively short period of time. The objection period to a proposed strict foreclosure is only twenty days. While this period is technically longer than the ten day notice requirement for a public or private sale, arranging a public or private sale is likely to take longer, especially if it is difficult to locate a private buyer or extensive advertising is required.
If the collateral is worth more than the outstanding debt owed to the foreclosing party, then the secured party will most likely be required to effect a public or private sale of the collateral because at least one of the Notified Persons is likely to object to a strict foreclosure. On the other hand, if the collateral is worth less than the outstanding debt owed to the foreclosing party, the foreclosing party must decide if it wishes to take title to the collateral or sell it in a public or private sale. Unless the equity interests are traded on a national exchange or the assets are simply commodity type items, the foreclosing party can only acquire the collateral at a public sale or through strict foreclosure. Strict foreclosure may be more efficient because of its lower transactional costs and relatively quick pace.
[1] See Sections 9-601(a) and (b) (general rights after event of default), 9-610 (public and private sales) and 9-620 (strict foreclosure) of Article 9.
[2] See Section 9-610(b) of Article 9.
[4] See Section 9-613(1)(E) (as to contents of notification), 9-612(b) (as to safe harbor timing of notification) and 9-611(c) (as to parties to be notified).
[5] See Section 9-611(e) of Article 9.
[6] Official Comment 7 to Section 9-610 of Article 9.
[7] See Section 9-615(a) of Article 9.
[8] See Section 9-615(c)(2) of Article 9.
[10] See Regulation D of the Securities Act of 1933.
[11] Official Comment 8 to Section 9-610 of Article 9.
[13] Section 9-610(b) of Article 9.
[14] Comment 2 to Section 610 of Article 9.
[15] See Sections 9-611, 9-612 and 9-613 of Article 9.
[16] Official Comment 7 to Section 9-610 of Article 9.
[17] See Section 9-615(d) of Article 9 (no differentiation between a public or a private sale is made).
[18] Section 9-610(c) of Article 9.
[19] See Official Comment 9 to Section 9-610 of Article 9.
[20] See Section 9-620 of Article 9, Official Comment 7 thereto and Section 9-621 of Article 9.
[21] See Section 9-620(c) of Article 9.
[22] See Section 9-620(d) of Article 9.
[23] See Section 9-620(c)(1) of Article 9.
[24] See Section 9-622 of Article 9.
[26] Official Comment 6 to Section 9-620 of Article 9.
[27] See Section 9-622(a)(1) of Article 9.