The primary investment thesis of a private credit lender is simple — get the loan repaid at maturity. Private credit lenders do not make loans as a means to acquire their borrower's business. There are circumstances, however, where private credit lenders must be prepared to take ownership when the borrower is distressed and there is no realistic prospect of near-term loan repayment. Becoming the owner of a borrower's business may very well be the loan recovery option of last resort.
There are different ways to implement a change of control or debt for equity restructuring, including an out-of-court conversion, a foreclosure sale under article 9 of the Uniform Commercial Code ("Article 9 Sale") and a Section 363 sale under chapter 11 of the Bankruptcy Code (a "Bankruptcy Sale"). Which strategic path to pursue depends on a host of factors, including cost, speed, degree of consensus, extent of operational distress and need to address other liabilities on the borrower's balance sheet.
In either an Article 9 Sale or Bankruptcy Sale, secured lenders are entitled to "credit bid" for their collateral using debt forgiveness as the purchase price to acquire the collateral. Credit bidding lenders can thus acquire the collateral comprising a borrower's business without making major changes to the enterprise and will assume those specific liabilities that are necessary to operate the business. Credit bidding lenders typically form a new acquisition vehicle ("NewCo") that will look very similar to the borrower. NewCo is likely to conduct the same operations from the same locations, serving the same customers with the same employees. NewCo may even conduct its business using the same name as the former borrower.
Outside of bankruptcy, a scenario like this may expose NewCo to unpaid claims from the borrower's creditors based upon so-called "successor liability" theories. The borrower's unpaid creditors may contend that NewCo is a "mere continuation" of the borrower/seller and that NewCo should be liable for the debts of the seller.1 Lenders considering "out-of-court" strategies, including an Article 9 Sale, will certainly prefer the speed and cost of this option. In certain circumstances, however, the specter of potential successor liability can outweigh the advantages of an Article 9 Sale. The risk of successor liability is greater when the sale is marked by evidence of wrongful or unfair acts, such as when the buyer knows that the seller will transfer the sale proceeds to the seller's shareholders and leave the seller's creditors unpaid.
The Bankruptcy Code, under section 363(f), allows property sales "free and clear of interests in such property" provided that certain conditions are met. The Bankruptcy Code, however, does not define the term "interest." As a result, courts have had to determine what "interests" can be expunged by a free and clear sale under section 363. While the term certainly includes a property interest in the asset itself (like a lien or mortgage), many courts (including the Second, Third and Fourth Circuit Courts of Appeals) have adopted a broad interpretation that considers "interests" to include obligations that are connected to, or arise from, the property being sold. Under this view, "interests" includes successor liability claims.2 Thus, in a credit bid acquisition via a Bankruptcy Sale, all creditor claims - even debts that are contingent and unliquidated - can be cut off through a court order. The practical value of this strategy was recently reinforced as the purchaser of
In 2019, substantially all of
Proskauer's Private Credit Restructuring team works with clients to formulate and execute simple and complex loan recovery strategies both in and out of court. Maximizing speed and minimizing cost are priorities for every lender-side debt restructuring, but there is no one-size-fits-all solution, particularly for change of control transactions involving a complex business. Contingent and unliquidated exposure for product defects, environmental contamination, labor and employment matters and long term contractual commitments can render an out-of-court solution infeasible. As illustrated by the recent skirmish in
Footnotes
1. Whether an entity is considered a "mere continuation" of the seller is a matter of state law. The court in Call Ctr. Techs., Inc. v.
2. See, e.g., In re
Private Credit Lenders - Navigating Successor Liability Issues
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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