Friendly Foreclosures Offer Alternative to Section 363 Sales
UCC Article 9 Process Is Underutilized Option

by Doug Bacon, Hudson Hollister

Jan 1, 2006

(TMA Global)

Troubled undersecured loans present special challenges for secured lenders, who while enjoying some recovery, also usually suffer a loss. Every penny spent, lost, saved, or recovered in the loan collection process adds to one side of this equation or the other. A cooperative Article 9 foreclosure under the Uniform Commercial Code (UCC), although rarely used, may be an ideal remedy for an undersecured lender.

Though it may sound oxymoronic, “friendly foreclosure” describes a scenario in which a financially challenged borrower willingly cooperates with its undersecured lender to facilitate a foreclosure sale. A friendly foreclosure can divest a borrower of its assets — its lender’s collateral — and deliver title to them to the lender or a third-party buyer. A borrower’s motivation to cooperate may stem from personal guarantees of its decision makers, a desire to preserve jobs (perhaps including the decision makers’), a good-faith desire to “do the right thing,” or some combination of these and other factors.

In some situations, a third-party buyer may have much in common with the distressed borrower in terms of overlapping ownership interests and managers. [1] Of course, Article 9 does not require a friendly or compliant borrower, but foreclosing on the assets of an uncooperative borrower — while occasionally the only viable remedy — presents challenges and risks that are not addressed in this article.

If sufficient value is involved, if the distressed business can survive long enough, and if there is sufficient buy-side interest, an undersecured lender often will benefit from a U.S. Bankruptcy Code Section 363 sale process in a Chapter 11 proceeding. The Section 363 sale process has become so commonly used that it is often the easier and preferable path. A buyer can emerge with a U.S. Bankruptcy Court’s imprimatur on the sale, embodied in a lengthy order that says in at least a dozen different ways that the buyer has clean title to the assets and that none of the former owner’s entanglements with its creditors will ever become a problem for the new owner.

However, despite the frequent use of Section 363 sales, they have not become less time-consuming or costly, and the undersecured lender involved usually ends up paying for that process, either directly or indirectly. Moreover, some distressed businesses cannot survive even an accelerated bankruptcy process without losing significant additional value. Another potential drawback to these sales is that some Bankruptcy Courts will not allow a Section 363 sale in circumstances in which only the secured lender benefits. [2]

The ideal candidate for using a friendly foreclosure is a moderate sized business with going concern value that is well in excess of substantial hard-asset value but less than its lender’s debt. If there is not meaningful going concern value to capture, the cooperation of the borrower and the mode of lien enforcement are less important. If there are not substantial hard assets, then it may be difficult for a lender to use its liens to capture the going concern value. The “assets” may be able to walk across the street and set up a new business, leaving the unpaid lender behind. As discussed later, if a lender does not have a collateral deficiency, there is increased likelihood that the foreclosure will be challenged by other creditors.

Mechanics of Friendly Foreclosures

Under UCC 9-610, a lender may sell collateral after the borrower’s default “at any time and place and on any terms,” so long as every aspect of the transaction is “commercially reasonable.” [3] The UCC specifically allows a foreclosing lender to prepare or process the collateral to make it more attractive to buyers and to choose between a public and a private sale. [4] The UCC requires a lender to send “reasonable” notice of an intended sale to the borrower; any secondary obligors, such as sureties; and, unless the collateral is consumer goods, any other party with a secured claim on the collateral that either has perfected the claim by filing or has notified the lender of the claim. [5]

In a typical friendly foreclosure, the lender, borrower, and buyer enter into a three-way foreclosure agreement modeled on a straightforward asset purchase agreement. The agreement is intended to effect the rapid transfer of the borrower’s business to the buyer as a going concern in an Article 9 foreclosure by private sale. The borrower should confirm that the value of the assets is less than the secured debt and affirm the lender’s right to foreclose in the manner specified in the agreement. To further allay a buyer’s potential concerns, the borrower also may make representations about its business that the lender is not in a position to provide.

Generally, a lender warrants to the buyer that it is entitled to convey title to the collateral in good faith, but it usually disclaims many of the warranties that customarily accompany the transfer of property of the kind being sold. [6] The buyer agrees to take the collateral in its current condition. The buyer also may assume some of the borrower’s specified liabilities but usually disclaims most of the borrower’s obligations, including taxes, employee benefit plans, trade debts, and tort liabilities. The buyer’s recourse to the lender almost always is contractually limited to the amount of consideration being paid by the buyer. If circumstances require it, the lender may finance a portion of the purchase price by specifying in the agreement that the buyer is taking title subject to a portion of the existing debt held by the lender.

Usually faster and less costly than a bankruptcy sale, a friendly foreclosure sometimes can accomplish essentially the same result as a Section 363 sale. Assuming the lender who brings the friendly foreclosure is the most senior secured creditor, the sale of the borrower’s assets under Article 9 wipes out the interests of all of the borrower’s other creditors. [7] Creditors who have no economic interest in the enterprise are afforded less opportunity to attempt to extract “holdup” concessions from a lender during the sale process. The parties are not subject to Bankruptcy Court procedures and need not hash over all aspects of a borrower’s history, value, and prospects in court.

In addition, as noted earlier, Article 9 requires notice to a smaller group of entities than does bankruptcy. A borrower’s customers and vendors usually need not be notified, [8] which may make it easier to maintain a borrower’s business than it would be if the company were in bankruptcy. A substantial part of the value lost in a distressed asset transfer may be avoided if a sale is accomplished before third parties become overly involved or distraught.

Potential Obstacles

Despite the potential advantages of friendly foreclosures, lawyers and other professionals typically are not as experienced with them as they are with bankruptcies. There is no established “safe harbor” process for foreclosures. Moreover, the parties usually operate in an atmosphere characterized by the ongoing threat of imminent collapse of the borrower’s business, and the lack of the calming influence of a bankruptcy stay of antagonistic creditors can create severe pressure for all parties. In addition, the parties must be mindful of three aspects of an Article 9 sale that may be obstacles to a fast, cost-effective foreclosure: the UCC’s inapplicability to sales of real property, the commercial reasonableness standard, and the prospect of successor liability.

Inapplicability to Real Property Sales. To maximize the sale price in an Article 9 friendly foreclosure, a lender’s goal is to offer the borrower’s business for sale as a single package. Because the UCC does not apply to real estate sales, Article 9 can prove to be an awkward vehicle for the sale of an entire business if significant owned real estate is involved.

Foreclosure procedures for real property differ widely from state to state; in many states, foreclosing on real property is far more difficult and time-consuming than is foreclosing on personal property under Article 9. Thus, it may be difficult or impossible for the buyer to obtain clear title to the real estate on the same timetable as the personalty. Such a buyer is placed in the uncomfortable position of having to close on only a portion of the business without being absolutely certain that related — and perhaps essential — real estate will be obtained or at what price. This challenge can be mitigated in many circumstances, but it is often the highest hurdle to a friendly Article 9 foreclosure.

Commercial Reasonableness. In addition, every aspect of a foreclosure sale under Article 9 must be “commercially reasonable.” When a lender foreclosing under Article 9 conducts a sale that is not commercially reasonable, it is not entitled to a deficiency judgment against the borrower for the amount by which the proceeds fall short of the borrower’s obligation. Friendly foreclosures may render deficiency judgments irrelevant; the lender may agree not to seek a deficiency judgment (which is likely worthless anyway) in exchange for the borrower’s cooperation. However, other creditors of the borrower who feel that a higher price could have been obtained may seek to invalidate a foreclosure sale by claiming commercial unreasonableness. In such a suit, the burden is on the lender to prove that the sale was commercially reasonable. [9]

The sale price, the sufficiency of efforts to find alternative buyers, and the lender’s general good faith in maximizing the value of the collateral are all considered by courts that review commercial reasonableness. A lender need not demonstrate that it obtained the highest possible price. In general, courts only declare foreclosure sales commercially unreasonable in cases in which lenders’ marketing efforts are obviously feeble and sale prices are much less than could have been achieved. Since a lender in a friendly foreclosure nearly always, as a business matter, tries to maximize the sale price, a finding of commercial unreasonableness should not be likely after a properly executed friendly foreclosure.

Most of the case law on commercial reasonableness comes from challenges brought by uncooperative borrowers, a risk that is eliminated in a friendly foreclosure. Challenges by borrowers’ third-party creditors are fairly rare. This makes sense because a foreclosing lender’s lien coverage usually exceeds the value of the assets at issue. A typical third-party creditor does not have a legitimate economic basis for a post-closing challenge of the sale.

Successor Liability. Another potential impediment to a friendly foreclosure is a buyer’s likely concern about the risk of liability for a borrower’s unsecured debts. At issue is the common-law doctrine of successor liability, which applies to sales of substantially all assets of a business. [10] The doctrine provides that a buyer of a business’ assets generally is not responsible for its debts. However, certain exceptions apply. If (1) the buyer agrees to assume liabilities, (2) the buyer is a “mere continuation” of the purchased business, (3) the transaction amounts to a de facto merger or consolidation of the buyer and the purchased business, or (4) the transaction was nothing more than an attempt to defraud creditors, courts impose liability.

In a friendly foreclosure, the buyer can avoid the first exception by expressly providing in the foreclosure agreement that it is not assuming any of the borrower’s liabilities. However, a buyer with some commonality of ownership, officers, and/or management with the borrower may have more difficulty avoiding the other exceptions.

The few courts that have addressed a buyer’s liability for the borrower’s debts in an Article 9 friendly foreclosure have tended to focus on the mere continuation exception. Unfortunately, their interpretations of that exception have varied widely. In most cases, courts are more likely to impose successor liability under the mere continuation exception if the same individuals who held controlling blocks of the borrower hold controlling blocks of the buyer. [11] Continuity of management and continuity of officers often are cited by the same courts as additional reasons for applying the mere continuation exception. [12]

However, at least one court has endorsed a standard in the Article 9 friendly foreclosure context that finds mere continuation when the buyer has paid “less than adequate consideration” for a borrower’s assets and has “at least one common officer [with the borrower] who was instrumental in the transfer.” [13] This standard could lead to a finding of mere continuation, regardless of ownership. At the other extreme, some courts have held that the mere continuation exception should be applied only when there is exact identity of ownership, at least when there is no evidence of fraud. [14]

On occasion, the mere continuation exception and the de facto merger exception have been discussed as though they were the same concept. [15] Further confusion of the exceptions might result from some courts’ suggestions that the mere continuation exception can apply if a buyer has given inadequate consideration for the sale. [16] Inadequate consideration for the sale and other evidence that the sale is an insiders’ transaction might be better suited to proving fraud than mere continuation.

Courts are more likely to impose successor liability on a buyer whose purchase is an obvious attempt by the borrower’s controlling individuals to shed the company’s debts and still keep their business. But it is not clear which descriptions of such underhandedness — mere continuation, a de facto merger, or fraud — will be used. It is likewise unclear what sorts of evidence will lead to a finding of successor liability. Continuity of ownership seems most likely to lead to such a finding, especially if the same individuals who owned the borrower own the buyer. However, a commonality of officers and management or a showing that the buyer did not give adequate consideration for the sale also may be important and may even lead to a finding of successor liability when no continuity of ownership exists.

Given the lack of consistency in courts’ applications of the successor liability exceptions in the Article 9 friendly foreclosure context, counsel involved in a friendly foreclosure must be careful to examine which precedents apply in their jurisdiction. Perhaps the clearest lesson to be gleaned from successor liability cases is that they are fact-driven. If any of the indicia of the sort of underhandedness discussed earlier are present, a buyer risks successor liability or at the very least a meaningful threat of post-closing litigation over the issue.

The successor liability danger is one reason the size of the deficiency of its claim is important to a lender’s decision on whether to pursue a friendly foreclosure. As a practical matter, and probably as a legal matter, courts will be less likely to impose successor liability or otherwise disturb a foreclosure sale if the secured lender incurred a substantial loss because that is probably the best evidence that the sale was legitimate and no other creditors were deprived of value.

Liability for a borrower’s tort claims may be imposed more readily than commercial claims on a buyer whose identity is similar to the borrower’s. For example, in EEOC v. SWP, Inc., a U.S. District Court in Indiana imposed the borrower’s employment discrimination liability on the buyer. The buyer had notice of the claim before the sale, and the court found there was “sufficient continuity” of “business operations”—meaning, among other things, that the borrower’s facilities, location, and employees were all retained by the buyer. [17]

Pragmatic Choice

Since bankruptcy sale approval orders are so appealing to a buyer and its advisors, a friendly foreclosure scenario must present a better deal, even after accounting for increased risk, than the buyer could obtain in a bankruptcy sale. It also must present the opportunity for enough additional value to improve the outcome for the lender. Nonetheless, circumstances in which the use of friendly foreclosures make good economic sense arise more often than the remedy is utilized. If both lender and buyer are proactive and pragmatic — and are assisted by equally pragmatic advisors — an Article 9 friendly foreclosure can be the best way to resolve an undersecured loan.


[1] As noted later in this article, a buyer that is too closely identified with the borrower may be at increased risk of successor liability.

[2] Clark, “Debate Over Section 363 Sales Simmers, The Journal of Corporate Renewal, December 2004, provides an excellent response to criticisms that sales under Section 363 unfairly favor secured creditors. Clark also compares Section 363 sales with Article 9 sales.

[3] UCC Article 9-610 (a), (b) (1999).

[4] Id .

[5] Id . Article 9-611.

[6] Unless the lender expressly disclaims them, the UCC deems it to automatically provide warranties of title, possession, quiet enjoyment, or whatever other warranties are customarily made concerning the types of property being sold. UCC Article 9-610 (d), (e).

[7] An Article 9 foreclosure sale does not wipe out any security interests that are senior to the foreclosing lender’s; the collateral remains subject to senior security interests after the sale. In an Article 9 friendly foreclosure, as in a Section 363 sale or any other method of disposing of the assets of a financially troubled borrower, the lender must perform a lien search to identify and evaluate all other existing liens on the borrower’s assets.

[8] Prospective buyers in friendly foreclosures may have concerns about Article 6 of the UCC, Bulk Transfers, which requires the purchaser of a significant part of another’s business to provide notice of the transaction to the seller’s creditors. This is rarely an issue because Article 6 exempts transactions that settle liens, including friendly foreclosures, from its bulk-transfer definition. UCC Article 6-103 (1989). Moreover, only five jurisdictions—Arizona, California, the District of Columbia, Indiana, and Virginia—have retained Article 6.

[9] See, e.g., Vines v. Citizens Trust Bank, 247 S.E.2d 528, 531 (Ga. Ct. App. 1978).

[10] Some friendly foreclosure buyers faced with successor liability suits brought by borrowers’ creditors have argued that a commercially reasonable Article 9 foreclosure sale automatically prevents the imposition of successor liability. The authors have not found any published court decision that adopts this view. See, e.g ., Glynwed, Inc. v. Plastimatic, Inc., 869 F.Supp. 265 (D. N.J. 1994); Continental Insurance Co. v. Schneider, Inc., 873 A.2d 1286 (Pa. 2005).

[11] See Glynwed, Inc., v. Plastimatic, Inc., 869 F.Supp.265, 275-77 (D. N.J. 1994) (imposing successor liability on Article 9 foreclosure buyer when three individuals who had held more than 30 percent of borrower now held the majority of the buyer’s shareholders ); Beck v. Virginia Sash and Door, Inc., 58 Va. Cir. 65 (Va. Cir. Ct. 2001) (imposing successor liability on Article 9 foreclosure buyer when two individuals who had held 65 percent of borrower now held 100 percent of buyer); see also Fiber-Lite Corporation v. Molded Acoustical Products of Easton, Inc., 186 B.R. 603, 609 (E.D. Pa. 1994).

[12] See Glynwed, 869 F.Supp . at 276; Virginia Sash and Door, 58 Va. Cir. at 2; see also Fiber-Lite Corporation, 186 B.R. at 606.

[13] Ed Peters Jewelry Co., Inc. v. C & J Jewelry Co., Inc., et al., 124 F.3d 252, 268 (1st Cir. 1997) (overturning lower court’s dismissal of successor liability claim brought by borrower’s trade creditor against buyer and remanding for jury consideration).

[14] See G.P. Publications, Inc. v. Quebecor Printing — St. Paul, Inc., 481 S.E.2d 674, 679-681 (N.C. App. 1997) (overturning trial court’s imposition of successor liability on Article 9 friendly foreclosure buyer, where trial court had allowed jury to find “mere continuation” under totality of the circumstances; holding that there must either be “ identity of stockholders and directors” between the borrower and the buyer, or “inadequate consideration” for the purchase, for successor liability to be imposed (emphasis added)); See also Gallenberg Equipment, Inc. v. Agromac Int’l., Inc., 10 F.Supp.2d 1050, 1055-56 (E.D. Wis. 1998).

[15] See, e.g., Glynwed, 869 F.Supp. at 275.

[16] Ed Peters, 124 F.3d at 268; G.P. Publications , 481 S.E.2d at 680.

[17] E.E.O.C. v. SWP, Inc., 153 F. Supp.2d 911, 917 (N.D. Ind. 2001); see also Glynwed, suggesting that there may be broader exceptions to the general rule of no successor liability in the strict products liability and labor law areas, at least in New Jersey.


Doug Bacon
Latham & Watkins LLP


Hudson Hollister
Latham & Watkins LLP


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