Article 9 of the Uniform Commercial Code (“UCC”) allows a secured creditor to dispose of collateral upon the default of the debtor and apply the proceeds of the disposition towards the secured debt. A secured party may proceed by either public or private sale.
However, a secured party utilizing this process must be sure to adhere to timing, notification, and other requirements, in order to avoid liability and/or damages. The UCC gives secured creditors leeway on how they decide to dispose of the collateral so long as the disposition is commercially reasonable and the secured creditor acts in good faith. A secured creditor and debtor cannot waive the commercial reasonableness standard. This article will focus on the steps a secured creditor must take in order to sell the collateral “reasonably” and explain why we do not usually recommend private sales, except in unusual circumstances.
Before proceeding with a secured party sale, a creditor should first verify that it possesses a perfected security interest in the subject collateral, and that there is sufficient value in the collateral to warrant a sale, after accounting for any tax liens or senior perfected security interests, including purchase money security interests, held by other creditors. A creditor should also verify that it either has possession or that the debtor does not object to the secured party taking possession of the collateral for purposes of disposing of it. If a debtor will not voluntarily permit a secured party to take possession or actively opposes the secured party’s efforts, it may then be necessary for the secured party to bring a legal action to enforce its right to take possession (UCC §9-609 “A secured party may [gain possession of its collateral]: (1) pursuant to judicial process; or (2) without judicial process, if it proceeds without breach of the peace.”)
Once the secured party has identified all interested parties and has secured possession, the next step is to send notice of the intended sale of the collateral (the “Notification”) to the debtor, other senior and junior lien holders, and secondary obligors (e.g., guarantors). The creditor should perform or update its lien search between 20 -30 days prior to the Notification date.
If a federal tax lien that is junior to the collateral exists, the Notification must be sent to the Internal Revenue Service (“IRS”) at least twenty-five days before the disposition. Currently in Massachusetts, the United States District Court federal tax lien search function at the Boston courthouse is not in operation, so a secured creditor would be prudent to assume there is a federal tax lien, send the Notification to the IRS, and adhere to the twenty-five day notice period rather than the ten day notice period discussed below. Furthermore, failure to identify a tax lien can subject both the purchaser of the collateral and the secured party to substantial liability for the outstanding lien.
After determining who receives notice, and assuming there are not any junior IRS liens, a creditor must give at least ten days’ notice prior to the sale to all parties entitled to receive the Notification. A creditor must be aware that while giving ten-days’ notice satisfies the reasonableness requirement under the UCC, the security agreement may require a longer notice period. Additionally, the Notification must contain the following information: (1) a description of the debtor and the secured party; (2) a description of the collateral; (3) method of the disposition; (4) a statement informing the debtor that it is entitled to receive an accounting of the unpaid debt; and (5) the time and place of a public sale or date after which the collateral will be sold at a private sale.
Private, as opposed to public, sales of collateral generate additional risks for a secured creditor and, generally, are not advisable. Most notably, courts will scrutinize private sales more closely than public sales because there is a presumption that a public sale will yield the best price and is there is less opportunity for collusive sales. For example, a recent Massachusetts case, Milliken & Co. v. Duro Textiles, LLC, 451 Mass. 547 (2008), scrutinized the Article 9 private sale of assets in which a corporation sold its assets to a “new” version of itself and held that the “new” corporation would still be liable for the unrepaid debts of the “old” corporation based on to the court’s conclusion that the private sale had been conducted in bad faith. Most troubling for lenders is that the referenced case suggested that the secured lender might also be held liable to third parties for what appeared to be a collusive sale.
In representing a lender on a troubled loan secured by all business assets of an operating company which is in an over-leveraged situation, it is not unusual for either borrower’s counsel or the “white knight” buyer’s counsel to suggest that the senior secured lender conduct a private secured party sale to the “friendly” buyer. Such a so-called “friendly” secured party private sale would permit the borrower to sell its assets to a related third party which could then carry on the business unencumbered by existing trade debt or junior liens. In addition, assuming there are no personal guaranties in favor of such other creditors, the borrower becomes effectively judgment-proof since it no longer has any assets and the business, now under “new” ownership has likely gotten “out from under” of its liabilities. While a private secured party sale in such a situation is tempting as a way to resolve a difficult lending situation and allow everyone to “move on,” a senior lender should be very hesitant in agreeing to this type of loan workout resolution. Private secured party sales can be challenged by junior secured creditors, unsecured creditors and even equity holders who feel that the sales price for the operating company’s assets was inadequate or unfair since they would have received no benefit from such sale and no opportunity to bid on the assets themselves at a public sale. If a sale is challenged, the senior secured lender who conducted such sale can be dragged into endless litigation with no opportunity to recover its legal fees and with possible exposure, as evidenced by the Milliken case, resulting from an alleged bad faith or collusive sale. The appearance of collusion is made worse if the foreclosing lender finances the purchase of the assets by the “new” corporation, effectively transferring its lien from the old corporation to the new and leaving other creditors with suspicions and questions about the legitimacy of the secured party sale.
In short, a creditor must exercise care when selling collateral under Article 9 of the UCC. Moreover, a creditor should think twice before choosing a private sale instead of a public sale, particularly where the prospective purchaser is related to or affiliated with the original borrower.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.