Welcome to Distressed Debt Legal Insights, Ropes & Gray’s periodic source of timely insights for professionals navigating the complex world of liability management and special situations finance. In this issue we discuss strict foreclosure, a state law remedy emerging as a potentially powerful alternative to chapter 11 and liability management exercises.

Foreclosure Basics

Foreclosure is an out-of-court restructuring tool rooted in state law, more specifically Article 9 of the Uniform Commercial Code (UCC), that allows secured creditors to enforce their rights against pledged collateral. Following a default, secured parties have the right to foreclose against collateral in full or partial satisfaction of their debt, subject to compliance with Article 9’s procedural requirements. The secured party can keep the collateral (strict foreclosure) or sell it in a commercially reasonable public or private sale.

In most multilender credit agreements, the collateral agent, acting at the direction of the “Required Lenders” (typically holding more than 50% of the debt), has the unilateral right to exercise remedies following an event of default. As such, it is the Required Lenders who control the timing, process, and outcome of the foreclosure process; minority lenders have limited ability to object given the lien and enforcement rights are held by the agent, and there is no court supervision or forum available for objections to be heard. In this article, we contemplate foreclosure under this common construct.

There is an important distinction between equity-level and asset-level foreclosure. In an equity-level foreclosure, the agent forecloses on the pledged equity of a holding company and takes ownership of the entities below (typically the borrower and its sister companies or subsidiaries) on an “as is” basis, without disrupting the operating entities’ contracts, employees, or licenses. This is typically the simpler and more attractive path. In an asset-level foreclosure, the agent takes the borrower’s underlying assets directly, which raises additional complexities discussed below.

Strict foreclosure permits the agent to take ownership of the relevant collateral in exchange for forgiving all or some of the debt. This process requires the borrower’s affirmative consent (or, for full satisfaction only, the borrower’s lack of objection), which may be an obstacle in some situations.1 If the agent and borrower agree, a strict foreclosure—particularly when the collateral consists of the equity of a holding company—provides a clean way to “hand the keys” to the agent without judicial intervention.

Benefits of Foreclosure

The primary benefit of foreclosure is that it is often faster and more cost-effective than a formal chapter 11, where administrative expenses and professional fees can be substantial. Foreclosure may also proceed on a private basis, avoiding the publicity, operational disruption, and vendor reaction that often accompany a chapter 11 filing. While liability management exercises (LMEs) can also be faster, cheaper, and more private than chapter 11, they frequently depend on interpretations of credit documentation that have generated significant litigation in recent years. A properly conducted foreclosure, by contrast, relies on well-developed statutory remedies rather than contractual loopholes.

A less obvious, but strategically significant, feature of foreclosure is its ability to bind minority lenders. Effectively, foreclosure allows a majority of lenders directing the agent to equitize debt through the foreclosure process and set forth the terms of a shareholders’ agreement that often may favor majority lenders—no chapter 11 required.

Foreclosure is particularly well suited for companies with viable businesses but overleveraged capital structures—so-called broken balance sheet problems—as distinct from companies with broken business models that may require the broader operational tools of chapter 11 such as lease or other contract rejections.

Coercive Foreclosure

Credit agreements generally require that lenders within a class receive pro rata treatment on account of their loans. As a result, following a strict foreclosure on pledged equity, each lender in the affected class must receive the same form and proportionate amount of equity. How, then, can foreclosure be structured to create dynamics similar to an LME, where lenders are incentivized to participate to avoid being disadvantaged?

The answer lies in creative legal structuring. Consider a scenario in which the goal is to convince lenders to sign a restructuring support agreement. The foreclosure itself cannot discriminate among lenders within the same class. However, once the foreclosure is complete and the debt has been canceled, the former lenders—now equityholders—arguably are no longer constrained by the credit agreement’s pro rata provisions. At that stage, the company may offer participating holders the opportunity to exchange their common equity for preferred equity or other enhanced rights. Because the underlying debt has been extinguished, the exchange does not implicate pro rata treatment under the credit agreement.

While such structures must be carefully analyzed in light of fiduciary duties and potential equitable challenges, they can recreate participation incentives without relying on controversial credit document interpretations. That said, post-foreclosure governance negotiations—including board composition, voting rights, and incremental financing needs—can be complex, particularly where multiple lenders with divergent interests become co-owners.

Key Risks and Limitations

While foreclosure offers meaningful advantages, practitioners must account for a number of risks that the structure does not address:

  • Default. Article 9 remedies are only available upon the occurrence and continuation of an event of default under the governing debt documents, which introduces both timing constraints and execution risk. Unlike chapter 11, which can be commenced proactively in anticipation of distress, foreclosure is reactive and may require lenders to wait until a payment, covenant, or other default has occurred (and, in some cases, applicable grace periods have expired). This can limit flexibility in managing liquidity runways and may accelerate value deterioration or stakeholder actions in the interim. Moreover, defaults that are subject to equity cure rights or waiver mechanics may create uncertainty as to whether foreclosure can proceed, particularly where sponsors or minority lenders seek to delay or block enforcement through strategic cures or litigation.
  • Junior Liens. Foreclosure implicates the rights of junior lienholders, who are entitled under Article 9 to receive notice and, in certain cases, may object to or seek to enjoin the transaction. While intercreditor agreements often include waivers of these rights (including standstill and “no contest” provisions), their scope, enforceability, and duration can vary and may be subject to challenge, particularly in distressed scenarios where junior creditors are out of the money and incentivized to litigate. Even where contractual waivers exist, compliance with strict notice and procedural requirements remains critical to limit litigation risk. In more complex capital structures, disagreements among creditor classes regarding valuation, the conduct of the foreclosure process, or post-foreclosure recoveries can lead to delays, additional transaction costs, or attempts to force a bankruptcy filing as an alternative forum for resolving disputes.
  • Legacy Liabilities and Asset-Level Complexities. An equity-level foreclosure does not address the borrower’s other liabilities. Material unsecured or legacy obligations remain in place and may impair the go-forward business plan. Shedding those liabilities typically requires an asset-level foreclosure or a chapter 11 filing, but asset-level foreclosures introduce their own obstacles, including successor liability risk, the risk of an involuntary chapter 7 filing and trustee investigation, heightened fraudulent transfer exposure, anti-assignment clauses in key contracts, and the need to develop a wind-down plan for the remaining entity. Moreover, unlike a Section 363 sale, a UCC foreclosure does not produce a court-approved order conveying assets free and clear of liens, claims, and encumbrances, exposing the foreclosing party to potential successor liability claims. And if assets are located in multiple states, a separate foreclosure proceeding must be conducted in each state.
  • Change-of-Control Triggers. Strict foreclosure on pledged equity will typically constitute a direct change of control at the entity whose equity is foreclosed on and an indirect change of control at that entity’s subsidiaries. If the borrower operates in a regulated industry (for example, health care, gaming, or broadcasting) or has material contracts with change-of-control provisions, the foreclosure must comply with applicable regulatory and contractual requirements.
  • Tax Consequences. Foreclosure may generate cancellation of debt income, producing ordinary income for the borrower unless an exclusion applies. Critically, the bankruptcy exclusion under Section 108 of the Internal Revenue Code (IRC) is unavailable in an out-of-court foreclosure. The insolvency exclusion may apply, but must be analyzed on a case-by-case basis. Debt-for-equity conversions may also trigger IRC Section 382 limitations on the use of net operating losses if ownership shifts by more than 50 percentage points.
  • Fraudulent Transfer Risk. A strict foreclosure may be subject to later challenge as a constructive fraudulent transfer because unlike a competitive sale process, strict foreclosure lacks a market-tested price, increasing valuation-based challenge risk. This vulnerability is particularly inherent in strict foreclosures because the two prongs of a constructive fraudulent transfer claim—lack of reasonably equivalent value and insolvency—are inherent to the circumstances that motivate a strict foreclosure in the first place: the borrower’s financial distress and lack of competitive bidding to support a value defense. While the Supreme Court’s decision in BFP v. Resolution Trust Corp. held that a properly conducted foreclosure sale price constitutes reasonably equivalent value, that holding was limited to real property mortgage foreclosures and may not extend to UCC strict foreclosures.
  • Automatic Stay Risk. A UCC foreclosure can be interrupted at any time by a bankruptcy filing. If the borrower or any party in interest files a petition before or during the foreclosure process, the automatic stay under Section 362 of the Bankruptcy Code will halt the proceedings.

Why This Matters

With approximately $1 trillion of high-yield debt coming due by 2028, a significant cohort of leveraged companies will face refinancing pressure in an environment that may not support easy maturity extensions. Higher base rates, tighter liquidity and continued sector-specific stress increase the likelihood that traditional amend-and-extend transactions will prove insufficient. Some will pursue chapter 11 or fully consensual out-of-court restructurings. Others may turn to LMEs, such as drop-downs or uptiers, notwithstanding the litigation and reputational risks that have accompanied certain high-profile deals.

Foreclosure offers a third path—one grounded in established statutory remedies rather than aggressive contractual interpretation. It can deliver many of the benefits sponsors and lenders seek in LMEs (speed, privacy, and control) while mitigating the risk of protracted document-based litigation. The ability of Required Lenders to direct remedies and bind minority holders can meaningfully shift negotiating leverage. In appropriate capital structures, the credible threat of a strict foreclosure may drive consensus more efficiently than months of contentious amendment negotiations.

That said, foreclosure is not a universal solution. Its viability depends on collateral structure (particularly equity pledges at the appropriate holding company level), scope of perfection of liens, intercreditor arrangements, consent mechanics, and careful adherence to Article 9’s procedural requirements. Stakeholders must consider the tax, successor liability, regulatory, and valuation risks discussed above, and recognize that even where a foreclosure is completed out of court, a subsequent bankruptcy filing may subject the transaction to scrutiny under avoidance, fiduciary duty, or equitable doctrines.

As maturities approach and liability management strategies continue to evolve, foreclosure is likely to become an increasingly prominent tool in the restructuring toolkit. Market participants who understand both its power and its limits will be better positioned as negotiations intensify in the coming refinancing cycle.