Contributed by Joshua Nemser
Asset sales are commonplace in the restructuring industry. Numerous cases and articles have been written of the “363 sale” process that takes place under the Bankruptcy Code. The assets of current and former household names such as Lehman Brothers, General Motors, Chrysler, and Blockbuster have all changed hands through that mechanism. Although it garners less attention in academia and in the media, creditors of financially distressed entities may also force asset sales pursuant to Article 9 of the Uniform Commercial Code. Perhaps because most secured creditors find themselves dealing with a chapter 11 case before they can exercise their remedies under Article 9, the law is less developed on the appropriate procedures for conducting an Article 9 sale.
Under Article 9 of the UCC, a secured creditor’s remedies include a sale of its collateral. As with a sale under section 363 of the Bankruptcy Code, the secured lender may choose to credit bid in connection with a sale of its collateral and thereby become the owner of the collateral. Section 9-610 of the UCC, however, requires that any disposition of the lender’s collateral be conducted in a “commercially reasonable” manner. Because, unlike a 363 sale, an Article 9 sale does not require judicial oversight, questions of process and price are examined after the fact. The recent Court of Chancery of Delaware decision in Edgewater Growth Capital Partners LP v. H.I.G. Capital, Inc. provides a detailed analysis of what satisfies the “commercially reasonable” standard of an Article 9 sale; in the process, it discusses the issues of process and price that lurk in the context of any distressed transaction.
The Article 9 Sale Process (abridged)
Except under limited circumstances that permit a creditor to accept a debtor’s collateral in full satisfaction of a debt, after default, a secured creditor must conduct an asset sale to recover value from the collateral.
Under UCC 9-610, “[e]very aspect” of such sale, “including the method, manner, time, place, and other terms, must be commercially reasonable.” A commercially reasonable sale includes one conducted “in conformity with reasonable commercial practices among dealers in the type of property” being sold.
A UCC sale must be “public” unless “the collateral is of a kind that is customarily sold on a recognized market or the subject of widely distributed standard price quotations,” in which case a private sale is permitted. A “public” sale means “the public has had a meaningful opportunity for competitive bidding,” and a meaningful opportunity implies “that some form of advertisement or public notice” precedes the sale and that the public has “access to the sale.”
Although the official comments to the UCC provide guidance as to key terms such as “public” and “meaningful opportunity,” and the UCC has an entire section dedicated to “commercially reasonable,” it is unsurprising that squabbles over such terms make their way into courtrooms; Edgewater is one such example.
The Pendum Sale
Edgewater, a private equity fund, purchased and consolidated several businesses that provided services related to the operation of ATMs. The resulting consolidated company became Pendum. The companies were acquired with “a relatively small equity check,” approximately $70 million in senior debt, and “millions more” in subordinated debt. The senior debt held a lien on substantially all of Pendum’s assets.
The consolidation proved to be somewhat unsuccessful: the company fell short of expectations and began to trip numerous performance related financial covenants on the debt. After each default on the senior debt, the company and its senior lenders executed an amendment to the credit agreement. After seven such occurrences of default and subsequent amendments of the credit agreement, HIG Capital, previously uninvolved with the company, began purchasing the company’s senior debt. As a condition to a ninth amendment of the credit agreement, HIG required that Edgewater-appointed directors be replaced by “experienced restructuring consultants.”
In anticipation of another default, the lenders and the company were faced with three options: (i) bankruptcy, (ii) an out-of court restructuring, or (iii) an Article 9 sale. Because a bankruptcy would have been “a disastrous route to take” and the company could not unite the lenders to orchestrate an out-of-court restructuring, the Pendum board and the senior lenders, led by HIG, negotiated a consensual Article 9 sale of all the assets of Pendum.
Pursuant to a sale agreement, Pendum hired a financial advisor, Miller Buckfire, to find a buyer for Pendum’s assets. Miller Buckfire conducted a “comprehensive” marketing process, but was unable to secure a buyer. Without having found a buyer by an agreed upon deadline, HIG commenced a public disposition of its collateral under Article 9. HIG sent notice of the auction to Edgewater, the other senior lenders, Allied Capital (the only subordinated lender), and the “potential buyers” that had been identified by Miller Buckfire. HIG also published notice of the auction in The Wall Street Journal. On the day of the auction, HIG was the only party that showed up and bid, and so, HIG purchased Pendum’s assets.
Edgewater, Pendum’s shareholder, filed a suit against HIG to challenge the sale. Edgewater’s primary goal was to avoid payment of a $4 million guaranty it made to Pendum’s senior lenders as a condition the third amendment to the credit agreement. Edgewater first argued that the sale was not a public sale. Edgewater also contended that, even if the sale was public, it had not been conducted in a commercially reasonable manner.
Public v. Private Sale
Under the credit agreement, senior creditors had the right to exercise their Article 9 remedies with 10 days’ notice. The sale agreement, however, allowed Pendum to take the first shot at selling the senior lenders’ collateral by hiring an investment bank and taking control of the sale process. Edgewater argued that the sale “must have been private” because Pendum’s assets were sold pursuant to the sale agreement, which was negotiated privately between Pendum’s board and HIG. The fact that the assets were publicly sold pursuant to a privately negotiated agreement did not make the sale itself public. As the court noted, the sale agreement did not convert the lenders’ subsequent Article 9 sale into a private sale:
If a court deemed a sale ‘private’ whenever a debtor-company negotiated substantial contractual concessions from the foreclosing party in order to give the debtor more of a chance to find another buyer, but the secured lender ends up buying it, it would create counterproductive incentives for secured creditors exercising their rights under the Uniform Commercial Code to the detriment of debtors.
The court emphasized that through Miller Buckfire, Pendum was able to “vigorously market” itself. Failure to consider the use of an independent financial advisor, the could observed, would have “perverse results.”
Reasonableness in the UCC sale context is analyzed through the lens of the type of property being sold. Just as a reasonable sale of real property would logically involve substantially different efforts than the sale of a pre-owned guitar, the court found that what is reasonable in the sale of a healthy company is not the same as in the sale of a distressed company. As the court noted, “the analysis turns on whether HIG sold Pendum’s assets in conformity with the practices of a financial advisor who sells distressed entities.” The court further emphasized,
A distressed — nay, in this case, basically insolvent — going concern must be sold in a commercially reasonable process that takes into account the stark reality of the company’s economic facts, not based on a false assumption that the foreclosing party must prop up the failing entity for the lengthy period that a very healthy going concern could use to test the market.
The court discussed numerous efforts that HIG undertook to ensure that the transaction was reasonable. Among them were HIG’s (i) provision of $10 million in interim financing to continue operating during the sale process, (ii) direct payment of Pendum’s financial advisor, and (iii) a “fiduciary out” allowing the board to consider superior transactions after the sale deadline. All-in-all, the sale process lasted 55 days and involved discussions with 67 potential buyers.
The court also discussed the reasonableness of the price paid for Pendum’s assets, finding that “the possibility of obtaining a higher price is ‘no preclusion of commercial reasonableness.’” Again, the court held that the sale price must be examined in the context of the company’s distress.
The court held that the sale was commercially reasonable in all aspects. Instead of an unreasonable sale process, “it was Pendum’s less than reliable financial reporting, operational mess, poor revenue stream, and distressed situation . . . that scared bidders away.” The case provides helpful guidance on somewhat ambiguous terms in the UCC and reminds us that sales in the distressed context are a unique creature. A distressed company on the auction block is often described as a “melting ice cube”: cash, goodwill, and operational capability tend to deteriorate at an increasingly rapid rate. Under Edgewater, a seller of such entities may consider this deterioration in conducting the sale.