It is an unfortunate reality that, as the economic repercussions of the COVID-19 pandemic continue to be felt, many companies — even those that were performing strongly at the start of 2020 — face significant headwinds. It is expected that as these financial challenges persist, more businesses will unfortunately need to consider seeking bankruptcy protection in the fourth quarter of this year and in 2021.
As some companies inevitably default under their credit agreements, these companies and their traditional lenders or specialty finance providers should consider all the tools in their arsenal, and not immediately assume that pursuing bankruptcy is the only option. One little-understood strategy that can be less expensive and take less time than bankruptcy can be found under Article 9 of the Uniform Commercial Code (UCC), and it’s called Strict Foreclosure.
In an Article 9 Strict Foreclosure procedure, a lender receives all or a portion of its collateral in exchange for reducing all or part of the obligations owed. Through this process, a lender can reshape the business through a newly created entity, acquiring assets and assuming only those liabilities that are helpful to the go-forward strategy for the reorganized business. While potentially valuable, it’s important to be mindful that Strict Foreclosure may not be appropriate in many sectors and circumstances, particularly if there are significant questions or disagreements around the valuation of the business.
People Issues & Management Incentives
An often-overlooked area that will impact the success of a Strict Foreclosure proceeding is people and incentives. Lenders must carefully consider how to retain and motivate existing company management in order to drive value in the business and facilitate a future 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 a MIP should take the following five factors into account in order to drive value and ensure a successful Strict Foreclosure process. Greater detail on each of these factors is included in the full Strict Foreclosure compendium.
- Meeting the Needs of Management – While a 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 guide the structure, it will let management know they are being looked after and improve the working relationship between all parties.
- Prior Compensation – Lenders need to understand the existing incentive structures through a detailed review of any previous or existing bonus structures 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.
- Proposed Capital Structure – When creating a 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 more equity proceeds available from the enterprise value at exit.
- Financial Forecast – It is vital to ensure that the MIP is financially viable based upon a careful review of any financial forecasts to confirm that the plan can be supported by projected cashflows and funding.
- Potential Exit – Article 9 processes are often part of a two-step sale over three to five years. Therefore, it’s critical to take an exit valuation into account in a MIP and include equity stakes large enough to properly incentivize management.
The law firm Chapman and Cutler LLP, working with CMA executives Mark Claster, Alec Haesler, and Jonathan Killion, prepared a compendium setting forth the Strict Foreclosure process and examining many of the issues involved. To learn more about the process and the legal complexities relating to an Article 9 procedure, please read the full compendium: Strictly Speaking: What Lenders Need to Know About Strict Foreclosure and Restructurings.
At Carl Marks Advisors, complexity is our specialty. If you are considering or have any questions about the use of a Strict Foreclosure process, please get in touch with a member of our team today.