Paving the Way: Proposed Changes to Bring Certainty to UCC Article 9 Sales

By Diana M. Peterson

Uniform Commercial Code (UCC) Article 9 foreclosures involving sales of membership interests in an entity holding title to real property are rising at a rate not historically seen before. Substantial revisions to Article 9 of the UCC were made in 1998 and adopted in all states. It was further amended in 1999, 2000, 2001 and 2010. Given this recent rise in UCC sales involving the membership interests of real property holding entities, and the fact that Article 9 does not directly allow foreclosures on real property, it might be a good time to consider legislative changes to Article 9.

Why are UCC foreclosure sales involving sales of membership interests in real property holding entities rising at such a rapid rate? One reason could be that during the COVID-19 pandemic, and post-COVID, most commercial real estate borrowers could not get a loan from a traditional lender. During this period, the commercial real estate (CRE) market suffered from high interest rates, tightening credit, and often vacant or mostly vacant buildings with high carry costs and little to no income stream that traditional lenders deemed too high-risk to make a loan. Due to these market constraints, many CRE purchasers were forced to seek financing from hard money, mezzanine and other alternative lenders to obtain the requisite funds to acquire real property needed to conduct or expand their businesses or to develop projects.

This demand for nontraditional CRE lending alternatives was so strong during COVID-19 and post-COVID that a new crop of lenders and funds arose to meet the burgeoning need. Some funds were raised solely to acquire well-located, very saleable real property for pennies on the dollar by making a loan with a UCC pledge to a borrower likely to default. Some funds even made loans to CRE purchasers who lacked the liquidity to tender an earnest money deposit.

In many such situations, the secured lender intended to ultimately foreclose on the membership interests of the borrowing entity holding title to the real property through an Article 9 UCC sale. Reminiscent of the residential subprime lending crisis of 2007-10, many of these COVID- and post-COVID-era CRE borrowers are now defaulting, in addition to those whose traditional lenders played the “extend and pretend” game.

Regardless of a lender’s initial intent, an Article 9 UCC foreclosure sale is an appealing remedy when default occurs. It allows the secured creditor to quickly and efficiently seize collateral and is far less costly and much quicker than filing a claim as a creditor in a chapter 11 case or pursuing judicial foreclosure. However, because an Article 9 sale does not require court involvement (vs. a judicial foreclosure or a § 363 sale, which happens under a bankruptcy court’s supervision), it affords the secured creditor far less protection than these other methods of repossessing collateral.

A UCC foreclosure on the membership interests in an entity primarily holding title to real property is essentially an Article 9 collateral workaround that many savvy lenders and their attorneys successfully utilize. Typical collateral in Article 9 foreclosure sales includes inventory, equipment, vehicles, accounts receivable, stocks, bonds and negotiable instruments — not real property. While Article 9 does not directly allow foreclosure on real property, lenders can still effectively foreclose on real property by seizing the membership interest in an entity that holds title to the real property, thereby gaining control of it through their ownership of the entity’s shares, which is considered personal property governed by Article 9. Such foreclosures are commonly used in mezzanine-financing situations where the collateral is the equity interest in a real property holding entity, allowing for a faster and far less complex foreclosure process than foreclosure on the real property itself.

Legislative Revision: Definition of “Commercial Reasonableness” in Article 9 Sales

The most glaring point of vulnerability for any secured creditor in an Article 9 sale, other than giving the debtor proper notice, is whether a court would find a sale “commercially reasonable” should it ever be challenged. If only one change to Article 9 (regardless of the type of collateral involved) could be recommended, it would be to provide a nationwide definition of “commercial reasonableness.” The change would substantially clarify the rights and obligations of secured parties and debtors, which would clearly guide attorneys and auctioneers hired to notice, advertise and conduct Article 9 UCC foreclosure sales.

While Article 9 currently requires secured creditors to sell collateral in a “commercially reasonable” manner, the UCC does not define the term. This often leads to costly litigation where a debtor argues that the sale was not conducted reasonably and the creditor is faced with the very real threat that the debtor could successfully challenge the sale.

Section 9-610(a) of the UCC gives a secured party the right to “sell, lease, license or otherwise dispose of any or all of the collateral.” However, § 9-610(b) states that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.” Section 9-627(b) further clarifies that a disposition is commercially reasonable if it is made “(1) in the usual manner on any recognized market; (2) at the price current in any recognized market at the time of the disposition; or (3) otherwise in conformity with reasonable commercial practices among dealers in the type of property that was the subject of the disposition.”

A secured creditor should typically take steps to protect itself in a UCC Article 9 sale by seeking to sell its collateral on the most recognized market that exists for that particular type of collateral, in the manner that the particular type of collateral is normally sold, taking the necessary steps to maximize the profit on the sale. Under § 9-610(b) of the UCC, the secured creditor may dispose of the collateral through a private or public sale, but under § 9-610(c)(1), the lender has the right at a public sale to purchase the collateral.

From a practical perspective, a secured creditor should only hire a qualified auctioneer to market and conduct the public sale. If an Article 9 sale involves the membership interests in an entity holding title to real property, the auctioneer will successfully market the real property for sale at auction. Moreover, the auctioneer’s detailed marketing plan should be well documented in the sale transcript.

A foreclosing secured creditor must also ensure that the sale is marketed for a commercially reasonable amount of time, such that there is adequate notice to potential buyers. Courts generally find a public sale commercially reasonable if the secured creditor provides sufficient notice to the public.

What length of time is recommended for marketing the sale? Many secured creditors would like to hold the sale in 30 days or less, and the notice provisions of Article 9 only require 10 days’ notice to the debtor. Since Article 9 does not define a “commercially reasonable” amount of time to market the sale before conducting it, what is recommended depends on the type of collateral owned by the entity whose membership interests are being sold. If the collateral mainly involves real property, at least 60 days of marketing is recommended, which is consistent with what is recommended to any owner of real property selling at an auction being held outside of Article 9. While a sale of the membership interests of an entity holding title to real property can be successfully marketed and conducted in less than 60 days, it arguably is not as defensible in court should the debtor sue the secured creditor for unlawful collection.

While courts have provided some guidance on what constitutes a “commercially reasonable UCC foreclosure sale,” the definition is still widely open to individual interpretation. Some examples of “commercially reasonable conduct” include advertising unique collateral well, holding a well-marketed-yet-cost-efficient sale, and utilizing experienced auctioneers who understand how to most effectively and cost-efficiently market the sale to potential buyers. A nationwide definition of “commercial reasonableness” could help clarify the rights and obligations of all parties involved and is a legislative change worth seriously considering. Beyond providing a nationwide definition of what is “commercially reasonable” to better integrate UCC Article 9 sales with real property transactions, the following legislative changes to Article 9 might be considered:

• • More Clearly Defining What a “Fixture” Is in Article 9 UCC Sales: Article 9 could more clearly define “fixtures” by establishing clear criteria for when an item becomes a fixture, considering factors like adaptation, attachment and intent of the parties.
• More Clearly Defining What “Related Real Property” Is in Article 9 UCC Sales: Article 9 could more clearly define what constitutes “related real property,” which would help avoid ambiguity in situations where collateral is closely tied to the real property but technically is not a fixture, such as with crops.
• Providing a Simplified Process for Fixture Filings in Article 9 UCC Sales: Article 9 could establish more streamlined procedures for fixture filings by reducing the amount of information required, providing a standardized process of filing a financing statement to perfect a security interest in a fixture, and allowing the electronic filing of fixture financing statements to expedite the process.
• More Clearly Establishing Priority Rules for Real Estate Liens in Article 9 Sales: Article 9 could establish clearer rules for determining priority between an Article 9 security interest in real property-related collateral and a traditional real estate lien, potentially based on the timing of filing or recording.
• Providing for Automatic Perfection for Certain Collateral in Article 9 UCC Sales: Article 9 could provide for automatic perfection of security interests in certain real property-related collateral like crops, where the secured party’s interest is already well-established through existing real estate documentation.

Conclusion

Making some or all of these changes to UCC Article 9, along with providing a national definition for “commercial reasonableness,” would provide a clearer, more comprehensive national framework for handling secured transactions that involve both personal and real property. Given the recent rise in Article 9 sales involving the sale of membership interests in real property holding entities, and the number of court cases involving disputes over what is “commercially reasonable” in an Article 9 sale, the time for considering these legislative changes has come.

Diana Peterson is CEO of AW Properties Global in Northbrook, Ill., and has more than 29 years of experience in law, real estate brokerage and auctions. She focuses on special-situations real estate consulting, brokerage and auctions.