THE LENDER’S GUIDE TO SECOND-LIEN FINANCING GEORGE H. SINGER The expansion in second-lien financings in recent years increases the likelihood that issues will arise in intercreditor agreements with increasing frequency and that those issues will require resolution in the courts. To date, only a handful of reported decisions address bankruptcy provisions, and existing case law does not provide a definitive set of rules. This article discusses, in general terms, the types of subordination, some of the more common provisions contained in intercreditor agreements, and the bankruptcy issues that become implicated in second-lien financing arrangements, including some of the issues that have been addressed in the courts. “One who takes so perilous a form of security as a second [lien] must ever be on the alert, lest by his want of diligence he may suffer the loss of his debt thereby secured.”1 A company has a variety of alternatives for structuring financing for its business. Historically, second-lien loans have been used in large part to provide a company with temporary incremental liquidity or a means to reduce existing debt. The landscape has changed. The increased George H. Singer is a partner in the Minneapolis, Minnesota office of Lindquist & Vennum PLLP, where his practice focuses on corporate and commercial law, including corporate finance, lending and credit transactions, financial restructurings and workouts, debtor-creditor relations, and bankruptcy. He may be contacted at [email protected]. Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 199 BANKING LAW JOURNAL creativity and presence of private equity sponsors and hedge funds in transactions and other changes in the financial markets over the past several years have lead to a trend toward the use of debt financing secured by second liens.2 Second-lien loan transactions, also referred to as tranche B loans, provide a number of benefits. For the borrower, favorable features include quick access to additional liquidity on relatively flexible and cost-effective terms that typically permit prepayment as funds become available through positive operating performance, refinancing, or other avenues. An institutional firstlien lender is able to reduce its credit exposure with the infusion of additional (subordinated) capital and facilitate its clients’ business and financing objectives. Second-lien loans are also favored by investors because they can provide an equity-like rate of return, yet afford priority secured creditor status (and often guarantees) to mitigate risk. The benefit of collateral security and potentially greater operational controls and protections through covenants and other customary features contained within secured credit agreements have greatly increased private investment in this financing option. The relaxation by first-lien lenders in lien exclusivity and willingness to permit second liens on all or part of the same collateral is typically predicated upon an agreement with the second-lien lender to subordinate some or all of its common-debtor rights or claims to the rights and claims of the senior, first-lien lender. Such agreements, referred to as intercreditor or subordination agreements, define the rights of the parties with respect to payment (payment or claim subordination), lien priority (lien subordination) or, frequently, both. The creditors of a common debtor contractually allocate credit risk and specifically address the consequences of default and bankruptcy. The second-lien lender agrees to accept junior rights to shared collateral and to subordinate, or waive, many of its rights for the benefit of the first-lien lender in the event the debtor defaults or becomes subject to a bankruptcy proceeding.3 Reference is often made to second lien arrangements as “silent second liens” because the subordinated lender, in its agreement with the senior lender, gives up rights to which it would otherwise be entitled, including the right to act and protect its position. While the use of second-lien loan structures has become increasingly common in recent years, the market remains in its infancy and, for the most part, what is “market” for various agreement provisions is dependent upon a 200 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING variety of factors.4 Moreover, there is no settled black-letter law regarding intercreditor arrangements at this point. There are only a handful of reported decisions that have addressed subordination issues in any detail and the results have been mixed. As such, there continue to be many risks and uncertainties surrounding the enforceability of certain pre-bankruptcy waivers and other provisions contained in intercreditor agreements. This article begins by discussing, in general terms, the types of subordination and some of the more common provisions contained in intercreditor agreements. The article then discusses bankruptcy issues that become implicated in second-lien financing arrangements, including some of the issues that have been addressed in the courts. TYPES OF SUBORDINATION Subordination is most often achieved contractually. The central feature of any contractual subordination arrangement is that the first-lien lender should ensure that its rights and remedies are as free as possible from interference from the second-lien lender.5 The senior, first-lien lender should also control the shared collateral and the actions of the subordinated, second-lien lender with respect to the common debtor (and often any guarantor) and the collateral. The junior creditor, by contrast, seeks to limit the control and actions of the senior creditor in order to ensure that its junior position has value in the event of a default or bankruptcy by the debtor. In appropriate circumstances, a transaction can be structured to achieve subordination. Finally, a bankruptcy court can in limited circumstances and as a matter of equity subordinate the claims of creditors in a bankruptcy proceeding. The types of subordination are generally described as follows: Payment or Claim (Debt) Subordination Complete payment or claim (debt) subordination provisions of an intercreditor agreement provide that the senior creditor will be paid prior to the junior creditor and require the junior creditor to turn over any payment received from a debtor, whether received from the collateral or otherwise, until the senior indebtedness is paid in full. Complete subordination therefore pro- Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 201 BANKING LAW JOURNAL vides a significant inducement for the senior lender. It is not, however, uncommon for intercreditor agreements to be less than complete. In other words, subordination arrangements often permit some regularly scheduled payments to the subordinated lender — interest, principal or both — unless the debtor is in default. In the context of the common debtor’s bankruptcy, all of these payment- or claim-subordination provisions entitle the senior creditor to receive all distributions allocable to the senior debt, along with all distributions allocable to the subordinated debt, until the senior debt is satisfied in full. Lien Subordination Lien subordination provisions of an intercreditor agreement define, and often alter, the rights and priorities of creditors’ liens in shared collateral and require the junior creditor to turn over to the senior lender proceeds received on account of shared collateral. The provisions of the intercreditor agreements that address subordination of the junior liens to those of the senior lender are not usually subject to significant negotiation. Structural Subordination Structural subordination can be achieved when indebtedness is incurred at different levels in the corporate family. For example, in the context of a parent-subsidiary structure, the debt issued at the parent- or holding-company level can be structurally subordinated to debt issued at the subsidiary-operating company level since subsidiary-level creditors have first claim to the subsidiary assets while parent-level creditors are limited to a claim on the assets of the parent holding company typically consists of equity in the subsidiary. The issues for lenders at the subsidiary level in a structurally subordinated transaction include ensuring that there are adequate restrictions and protections in place with respect to intercompany dividends and transactions. Equitable Subordination The bankruptcy laws enable bankruptcy courts to “sift the circumstances surrounding any claim” against the debtor or the bankruptcy estate in order 202 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING to avoid unfairness in the distribution of assets.6 Therefore, a bankruptcy court has the authority to subordinate claims in cases of inequitable conduct by the creditor.7 COMMON NON-BANKRUPTCY PROVISIONS There are a number of non-bankruptcy law provisions in intercreditor agreements that are designed to define the rights of lenders with claims against a common debtor and common collateral. Following are some of the frequently negotiated, non-bankruptcy provisions: Payment or Claim (Debt) Subordination Caps on Senior Debt Second-lien lenders often seek to negotiate caps on the total outstanding indebtedness to the senior, first-lien lender that will enjoy the benefit of the senior lien. The caps can take the form of an absolute dollar cap placed on the total amount of outstanding debt secured by the senior lien or couple the maximum senior debt limitation with separate caps on each component of the overall credit facility. Another way caps can be addressed is through provisions in the intercreditor agreement limiting or prohibiting the funding of additional term loans (or reloading outstanding loans) to achieve a reduction in the senior debt. One of the main purposes of these caps from the secondlien lender’s perspective is to preserve perceived collateral value (i.e. equity) for the benefit of the junior creditor by placing contractual limits on the indebtedness subject to the senior, secured lien. From the senior lender’s perspective, a dollar cap may need to include a cushion to allow room for growth or over advances under the facility. In addition, reimbursement or payment obligations associated with indemnity obligations, interest, fees (including prepayment fees, termination fees, attorneys’ fees and enforcement expenses), bank product costs and other non-advanced sums arising under the credit documents or in connection with the banking relationship must be considered in order to ensure that such amounts are afforded senior lien status even though the aggregate debt might exceed any negotiated cap.8 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 203 BANKING LAW JOURNAL Blockage Periods Unless the junior lien lender’s interest justifies “deep” subordination (e.g., complete, standstill subordination) due to the nature of the debt (e.g., seller financing) or the identity of the second-lien lender (e.g., insider or affiliate of the borrower)9 or there is an event of default under the senior credit facility, intercreditor agreements often permit the borrower to pay and the junior creditor to receive regularly scheduled principal and interest payments. The occurrence of a triggering event, such as a default10 under the senior credit facility or the borrower’s bankruptcy, typically precludes payment on subordinated debt.11 The central issue for negotiation is the “blockage period,” the length of time that payments should be barred before the junior lender is able to receive payment. There are also issues surrounding whether or not notice is required to be given by the senior to the junior lender in order to trigger a payment blockage. The approaches and issues can be generally summarized as follows: • Bankruptcy. Intercreditor agreements usually entitle the senior lender to receive payment in full in cash before the junior lender can receive any payment or distribution. • Absolute Payment Bar. Intercreditor agreements typically preclude any payment on subordinated debt as long as the triggering event exists, with no limitation as to time. An absolute payment bar is typically triggered upon a payment default and, depending on the extent to which the junior lender is subordinated, other defaults under the senior facility. • Limited Payment Bar. Some intercreditor agreements preclude any payment on subordinated debt during an agreed upon blockage period in the event that a triggering event other than a payment default or bankruptcy becomes implicated (e.g., covenant default). Junior lenders will frequently attempt to limit the payment bar to material defaults. • Notice. In the event that there is an absolute payment bar because the senior lender has not received payment for example, no notice is typically required to be given to the junior lender under the intercreditor agreement. The absolute payment bar provisions of the intercreditor agreement are triggered. Conversely, junior lenders typically insist on being given 204 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING notice in the event that the triggering event giving rise to the payment bar is attributable to a non-monetary default. If a large number of second-lien lenders in the transaction are subject to the intercreditor arrangement, it is wise to designate a representative for purposes of notice and otherwise. • Limits on Blockage Periods. Junior lenders will often seek to limit the number of (and interval between) payment blockages that may be imposed during the course of a specified period (e.g., no more than [x] blockages per 360/365-day period, or no more than [x] blockages over the life of a loan). • Common Blockage Periods. Although blockage periods are subject to significant negotiation, they typically coincide with the “standstill” or “standby” periods set forth in intercreditor agreements which limit the junior lender’s right to exercise remedies or otherwise act.12 These periods should, from the first lien lender’s perspective, be long enough to permit a workout or other collection strategy free from interference from the junior lender.13 A 60-day blockage or standstill period is generally regarded as shorter than customary, while more than 180 days would exceed what is typically encountered in most intercreditor agreements in which deep subordination is not contemplated (although periods ranging from 270 to 360 days are by no means aberrational). • Catch-Up Payments. It is not uncommon for junior lenders to seek to recapture payments that have been missed during any blockage period upon expiration of that period. The first-lien lender’s perspective on catch-up payments is typically dependent on the perceived financial condition of the borrower. Catch-up payments will not be allowed under any circumstance to the extent that the payment, if made, would trigger a default under the senior facility. Avoidance and Reinstatement Stipulations should be included in intercreditor agreements that revive the amount of senior debt previously paid and thought to satisfy the first-lien arrangement, but are subsequently required to be disgorged or recaptured as a preferential or other voidable transfer. From the first-lien lender’s perspec- Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 205 BANKING LAW JOURNAL tive, the terms of the intercreditor agreement should be reinstated to the extent any payment received and applied to the senior debt is later required to be disgorged. The second-lien lender typically resists a requirement to return proceeds that it received after discharge of the senior debt but before the first-lien lender is actually required to disgorge a voidable payment. Lien Subordination No Contest of Liens Intercreditor agreements commonly contain provisions to the effect that neither secured party will challenge the validity, perfection, or priority of the other’s liens in the shared collateral, except to the extent necessary to enforce the agreement itself. Most modern agreements also preclude the parties from encouraging or supporting the efforts of third parties to challenge the liens of the lenders. Liens Subject to Subordination Second-lien lenders often attempt to confine their subordination to those liens granted to the junior lenders under the credit documents evidencing the second-lien loans. Similarly, second-lien lenders attempt to restrict the liens to which priority is yielded to those liens of the senior lender that arise under the credit documents evidencing the senior loans. The senior lender will often insist that any lien it obtains, whether under the senior lender’s credit documents, a bankruptcy proceeding (e.g., replacement liens granted as adequate protection or under a DIP bankruptcy financing arrangement14) or otherwise, should be superior to any lien obtained at any time by the second-lien lender. Any limitation or cap on the senior debt in the intercreditor agreement15 naturally places the nature and extent of the parties’ respective liens in issue. Validity and Priority of Senior Liens Intercreditor agreements almost always contain explicit statements as to the validity and priority of the senior liens, notwithstanding the time, order, 206 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING manner, or method of creation, perfection or priority of the respective security interests. Second-lien lenders often request an exemption or carve out from lien subordination by conditioning lien subordination upon the validity, perfection, and non-avoidance of the liens of the first-lien lender with respect to the shared collateral. The rationale for the carve out is to preserve the perfected, but contractually subordinated, lien position of the secondlien lender in the event the senior lien is avoided in an insolvency proceeding as well as to fend off a bankruptcy trustee’s attempt to claim a superior right to the proceeds of the collateral to the extent of the avoided lien.16 Standstill Periods Intercreditor agreements routinely require second-lien lenders to refrain from taking certain enforcement actions, notwithstanding the occurrence and continuation of defaults under their credit documents. In other words, junior lenders are required to forbear from exercising their rights and remedies under the credit agreements and applicable law for a mutually agreed upon period of time frequently referred to as a “standstill” or “standby” period.17 Since first-lien lenders often have the benefit of the cushion afforded by the collateral, they are more likely to give the borrower time to cure defaults or develop a plan for addressing the outstanding obligations (which may include bankruptcy). Second-lien lenders typically have little, and often no, such cushion and would prefer to foreclose immediately — particularly if the value of the collateral is deteriorating. A significant issue for both senior and junior lenders is the duration of the standstill period.18 The standstill period, whatever its duration, should not begin until the senior lender receives written notice from the junior lender that an event of default has occurred and that the junior lender intends to start an enforcement action. Notwithstanding the expiration of the standstill period, most intercreditor agreements preclude the junior lender from commencing an enforcement action if the senior lender “diligently pursuing” such an action or is precluded from doing so by applicable law.19 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 207 BANKING LAW JOURNAL Release of Liens Parties to intercreditor agreements often include provisions in those agreements and the junior credit agreements addressing the circumstances under which the second-lien lender is required to release its liens in collateral securing the subordinated debt. As part of a restructuring or forbearance arrangement implemented after an event of default, it may, from both the borrower’s and the first-lien lender’s perspective, be desirable to make certain dispositions outside the ordinary course of business that are usually precluded under the credit agreements. A restructuring or liquidation plan outside of bankruptcy may be frustrated absent appropriate provision in both the intercreditor agreement and the junior credit agreement that eliminates the necessity for the junior lender’s consent in defined circumstances. As a measure of protection for the first-lien lender, the intercreditor agreement should also include an irrevocable power of attorney to enable the filing of lien releases in the event the junior lender refuses to do so. It is, however, important to recognize that lien release provisions are often resisted by second-lien lenders. Moreover, waivers in intercreditor agreements designed to protect the finality of a disposition of the collateral effectuated by first-lien lenders may not be enforceable.20 Cure and Buyout Rights Cure Rights Second-lien lenders occasionally want to address cure rights with respect to defaults under the senior facility in the intercreditor agreement. The right of the subordinated lender to cure should be conditioned in a number of respects. First, only those defaults capable of cure, such as payment defaults, should be subject to such an agreement. Second, there should be defined parameters on the time within which the junior lender should be able to cure the defaults so that any cure period does not effectively operate as a forbearance period at a time when the senior creditor may need to take immediate action. 208 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. Buyout Rights THE LENDER’S GUIDE TO SECOND-LIEN FINANCING In order to regain control in a default situation, second-lien lenders in certain circumstances seek to include in the intercreditor agreement the right to purchase the senior debt at par. Any buyout right is customarily made without representation, warranty or recourse (other than, perhaps, for due authorization). Select Credit Agreement Issues Cross Defaults It is quite common for the senior and junior lenders to include crossdefault provisions in their respective credit agreements. The senior lender will undoubtedly insist upon such a provision in order to ensure an entitlement to act in the event the junior lender has the right to do so. Shared Credit Agreements The use of a single credit agreement for loans made by first- and secondlien lenders should be avoided. In addition to drafting complexities of a shared credit agreement, at least one court has viewed the separate lending positions as a unified, secured claim for bankruptcy purposes.21 Prepayments First-lien lenders often seek to limit the ability of the borrower to prepay the subordinated, secured debt until the senior indebtedness has been paid in full. Provisions relating to prepayment are typically covenants addressed in the senior credit facility, a breach of which would constitute a default but would not necessarily provide recourse against the prepaid second-lien lender. Amendments Senior credit agreements often restrict the borrower from making amendments to the junior credit agreements without the senior lender’s prior Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 209 BANKING LAW JOURNAL written consent. Particularly troublesome are amendments that increase the amount of principal, the rate of interest, the timing of payments, the maturity of the loan or otherwise make the borrower’s performance more burdensome or otherwise adversely affect the position of the senior lender. From the senior lender’s perspective, agreements to lend and permit subordinated secured indebtedness were premised on a certain set of expectations that should not later be frustrated. Junior lien lenders similarly seek to restrict certain amendments to the senior credit agreements. Successors and Assigns Both parties to an intercreditor agreement typically require the agreement to inure to the benefit of and be binding upon successors and assigns. Although successor and assignment clauses are customary and not usually controversial, more comprehensive arrangements include covenants requiring the second-lien lender to provide any assignee notice of the arrangement (and may in fact condition any assignment on the assignee’s acknowledgment of the intercreditor agreement). In order to impart notice to potential assignees, a first-lien lender should require the second-lien lender’s financing statements and other perfection documents to specifically provide that its debt and lien priority are subject to an intercreditor agreement. First-lien lenders should view negotiations of intercreditor agreements with a view towards a potential exist strategy (e.g., assignment) — an unfavorable arrangement might adversely affect a third party’s desire to purchase the position in a distress situation. COMMON BANKRUPTCY PROVISIONS The intercreditor agreement provisions that address bankruptcy issues are often the most negotiated portions of the agreement. A creditor whose interest is secured by a lien in the property of the debtor is afforded a number of rights (and leverage) in a bankruptcy proceeding. A first-lien lender’s desire to control its own destiny as free as possible from interference by the junior lender is particularly acute in the context of a common debtor’s bankruptcy proceeding. Therefore, most intercreditor agreements include a sig210 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING nificant number of provisions relating to bankruptcy. A second-lien lender is usually benefited by as much silence as possible with respect to bankruptcy issues so that it has a meaningful voice in the bankruptcy process.22 Most bankruptcy-related provisions in the intercreditor agreement require the second-lien lender to waive certain rights as a secured creditor (including statutory rights) that could otherwise be asserted in the context of the common debtor’s bankruptcy. Some of the most common bankruptcy waivers and provisions can be summarized as follows: Cash Collateral and Adequate Protection A first-lien lender will often include provisions in the intercreditor agreement by which the second-lien lender will be deemed to have consented to the debtor’s use of cash collateral in any bankruptcy proceeding to the extent of any consent given by the first-lien lender.23 These provisions are typically coupled with a waiver of the right to contest the first-lien lender’s request for adequate protection. Although the second-lien lender is occasionally required to waive the right to seek adequate protection without the senior lender’s consent, typically the first-lien lender agrees to allow the second-lien lender to obtain adequate protection against any diminution in the value of its pre-petition liens on the collateral provided that it is clear that any replacement liens are subordinate. Conversely, second-lien lenders have with increasing frequency been able to reserve the right to object to the first-lien lender’s cash collateral arrangement on grounds other than adequate protection. Debtor-in-Possession (“DIP”) Financing A debtor-in-possession often needs financing during the course of a bankruptcy case in order to fund continuing operations. That financing is almost always secured by super-priority priming liens on collateral senior to the first-lien and second-lien loans.24 Intercreditor agreements often make advance provision for the senior lender’s right to provide DIP financing and include a waiver of the right to object. It is important from the first-lien lender’s perspective to make explicit that the subordination provisions of the intercreditor agreement govern all liens of the second-lien lender, however Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 211 BANKING LAW JOURNAL and whenever obtained, in order to ensure that any DIP financing offered by the junior lender, directly or indirectly, does not prime (or become pari passu) with the first-lien loans.25 Since the second-lien lender ordinarily has a strong interest in preserving going-concern value and preventing the liquidation of the debtor’s business, it may insist upon being able to have the right to provide DIP financing, on a priming or pari passu basis in the event the first-lien lender declines to provide it. Automatic Stay A first-lien lender will commonly require an agreement that includes an advance waiver by the second-lien lender of its right to object to any request by the senior lender for relief from the automatic stay.26 A similar provision in the intercreditor arrangement is often made to bar the second-lien lender from seeking such relief except in narrowly defined circumstances (which may include the court’s grant of stay relief to the first-lien lender). Proofs of Claim As part of the intercreditor arrangement, it is common to include a provision authorizing the senior creditor to file a proof of claim on behalf of the junior-lien lender in the event that the junior creditor fails to do so within a specified period in advance of the claims bar date. Post-Petition Interest First-lien lenders are well advised to include a provision in intercreditor agreements addressing the parties’ rights to recover post-petition interest during the pendency of the bankruptcy proceeding. Issues can arise in the absence of unequivocal language in the intercreditor agreement.27 Plan Confirmation As part of the intercreditor agreement negotiations, a first-lien lender may attempt to obtain the second-lien lender’s advance commitment to sup212 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING port any plan favored by the senior lender. From the first-lien lender’s perspective, a dissident second-lien lender can make confirmation of a common debtor’s plan of reorganization difficult (and perhaps not possible). The second-lien lender will resist making such an advance concession and will want to preserve the right to use plan confirmation as an opportunity to negotiate its treatment with the common debtor and the first-lien lender. Voting Rights First-lien lenders often require second-lien lenders to agree to a variety of voting restrictions and blanket agreements permitting the senior lender to vote the junior lender’s claims in connection with plan confirmation. Sale of Collateral A material aspect of intercreditor negotiations frequently revolves around the first-lien lender’s position that the second-lien lender be required to give its advance consent to any sale of the debtor’s assets under § 363 of the Bankruptcy Code that is supported by the first-lien lender.28 While this degree of silence for the second-lien lender is often objectionable, a competitive sale process (e.g., sale subject to higher and better offers), oversight by a creditors’ committee and the United States Trustee and bankruptcy court approval are a few of the grounds pointed to by the senior lender in support of the agreement. Additionally, lien release provisions in intercreditor agreements bolster the first-lien lender’s position in the event of a bankruptcy sale. Other Provisions There are a host of other provisions and waivers that may be contained in intercreditor agreements that attempt to block certain actions without the consent of the first-lien lender, including waivers relating to the right of the second-lien lender to exercise rights and make an election under Bankruptcy Code § 1111(b), request conversion or dismissal of the bankruptcy case, file a competing plan, and commence an involuntary bankruptcy or insolvency proceeding against a common debtor (or join in any such proceeding). Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 213 BANKING LAW JOURNAL BANKRUPTCY ISSUES As indicated previously, intercreditor agreements contain a number of provisions that are designed to address in advance the rights and obligations of the parties in the context of a bankruptcy proceeding commenced by or against a common debtor. Nevertheless, parties and their counsel all too often fail to sufficiently account for how these provisions will actually play out in the bankruptcy proceeding during the course of their negotiations of the debt financing arrangements. Statutory Framework The Bankruptcy Code specifically addresses subordination agreements. Section 510(b) provides that “a subordination agreement is enforceable in a [bankruptcy] case…to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”29 The legislative history of the statute makes it clear that bankruptcy courts are to enforce subordination agreements unless, in a reorganization case, the class that is the beneficiary of the agreement has accepted a plan that waives its rights under the agreement.30 Bankruptcy Waivers (General) As a general proposition, bankruptcy courts do not favor pre-bankruptcy waivers of rights afforded under the Bankruptcy Code. Most bankruptcy decisions refusing to enforce pre-bankruptcy waivers, however, arise in the context of waivers of protections afforded a debtor under the Bankruptcy Code that were given prior to the bankruptcy filing.31 However, a negotiated arm’s-length intercreditor agreement entered into between sophisticated creditors and containing bargained-for waivers does not implicate the same set of concerns as an agreement in which the debtor waives rights — there is no adverse impact from such an agreement upon the debtor’s estate or on the rights and recoveries of other creditors.32 Enforceability Few courts have addressed specific issues relating to the enforceability of 214 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING waivers and restrictions contained in pre-petition intercreditor agreements. The core issue for the courts and legal counsel appears to be a clash between conflicting principles — one being the enforcement of pre-petition subordination agreements and the other being preservation and enforcement of fundamental bankruptcy rights and procedures. Select Decisions The few decisions that have addressed the enforceability of waivers and other issues relating to intercreditor agreements to date have produced different results.33 As such, there is no definitive answer to the question of whether generally accepted provisions in intercreditor agreements will be enforced in bankruptcy. Adequate Protection and Automatic Stay Waivers The bankruptcy court in Beatrice Foods Co. v. Hart Ski Manufacturing Co.34 approved the subordination of a claim regarding the order of payment but held that the Bankruptcy Code “guarantees” every secured creditor certain rights notwithstanding subordination and the seemingly broad language of Code § 510(a), including: (i) the right to seek relief from the automatic stay, (ii) the right to vote for or against any plan, (iii) the right to have its interest adequately protected, and (iv) the right to assert claims. Any rights unrelated to priority of payment “cannot be affected by the actions of the parties prior to the commencement of a bankruptcy case when such rights did not even exist.”35 The court concluded that any other interpretation of § 510(a) “would be totally inequitable.”36 Voting Waivers/Restrictions The bankruptcy court in Bank of America v. North LaSalle Street Ltd. Partnership (In re 203 North LaSalle Ltd. Partnership)37 invalidated a provision commonly found in intercreditor agreements requiring the subordinated lender to relinquish its voting rights in bankruptcy. The court indicated that the parties cannot be forced by private, pre-petition contract to waive fun- Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 215 BANKING LAW JOURNAL damental Bankruptcy Code rights and protections.38 In addition, the court found that the common meaning of “subordination” for purposes of Bankruptcy Code § 510(a) relates to the ranking of claims for purposes of distribution, not the relinquishment of statutory rights. Notwithstanding LaSalle, other courts have found plan voting waivers and restrictions in pre-petition intercreditor agreements to be enforceable. For example, the district court in In re Winter Urban Broadcasting of Cincinnati, Inc.39 upheld the validity of a waiver allowing the first-lien lender to file a proof of claim and vote the claim of a subordinated lender in favor of a plan.40 Similarly, the bankruptcy court in In re Aerosol Packaging, LLC enforced an intercreditor agreement that authorized the senior lien holder to vote the claims of the junior in bankruptcy, holding that the Bankruptcy Code does not preclude a party from negotiating away a substantive right.41 DIP Financing/Cash Collateral Waivers In In re New World Pasta Co.,42 the second-lien lenders objected to motions seeking to approve DIP financing, cash collateral and adequate protection. The lenders asked the bankruptcy court to strike certain provisions of the proposed orders that would have recognized and given effect to provisions of the intercreditor agreement including, among other things, certain waivers of adequate protection and voting. The second-lien lenders argued that the “offending language” contained in the orders deprived the creditors of “fundamental bankruptcy rights and protections that cannot be traded away in pre-petition agreements….”43 The bankruptcy court approved the motions, but embraced the second-lien lenders’ views with respect to reserving the junior creditors’ right to challenge the enforceability of the waiver provisions in the intercreditor agreement. The court issued an order that included revised language. Intercreditor Contests The Chapter 11 debtor in In re American Remanufacturers, Inc.44 sought relief in bankruptcy for the purpose of conducting a sale of all of its assets pursuant to § 363 of the Bankruptcy Code. The debtor’s first-lien credit 216 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING facility, which was obtained less than nine months prior to the bankruptcy, consisted of $50 million of revolving and term loans. A second-lien credit facility of $40 million was also secured by substantially all assets. The lenders entered into an intercreditor agreement that, among other things, included a cap on the total amount of first-lien obligations to which the second lien would be junior. On the first day of the case, the debtor sought approval of a DIP financing arrangement to be provided by the first-lien lenders. The second-lien lenders, however, would not consent to being primed. The junior lenders argued that the intercreditor agreement would render any lien granted to the first-lien lenders pari passu with that of the second lien-holders. In a preliminary ruling on the matter, the bankruptcy court agreed. The first-lien lenders, unwilling to risk losing priority of the first lien, withdraw the offer to provide DIP financing. Since the first- and second-lien lenders were unable to reach a negotiated resolution, the debtor had no alternative but to convert the bankruptcy case to a Chapter 7 liquidation. The assets of the company were sold for less than $10 million and 1,400 employees lost their jobs.45 The American Remanufacturers case illustrates both the importance of giving careful consideration to the terms of intercreditor agreements and the impact that second-lien financing arrangements can have on a bankruptcy case and the parties’ positions. Rule of Explicitness The “rule of explicitness” was developed under the Bankruptcy Act as an equitable theory of contract interpretation. It was used to determine whether a first-lien lender could, as part of its claim under an intercreditor agreement, recover post-petition interest that had to be paid before any distribution could be made to the subordinated creditor.46 Under the rule, courts had historically required that the language in the intercreditor agreement had to be explicit and unequivocal in order to overcome the generic prohibition on the recovery of post-petition interest.47 However, the Court of Appeals for the First Circuit in Bank of New England Corp. v. Branch48 concluded that the rule of explicitness did not survive the enactment of the Bankruptcy Code49 and vacated a lower court’s ruling denying a first-lien lender’s request to con- Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 217 BANKING LAW JOURNAL strue the intercreditor agreement at issue as permitting the senior lender to recover post-petition interest prior to any payments to the junior lender. Other Issues There are a host of other issues that can arise in the context of an intercreditor agreement and the often competing interests of first and second-lien lender when their common debtor seeks relief in bankruptcy. For example, in Contrarian Funds, LLC v. Westpoint Stevens, Inc. (In re Westpoint Stevens, Inc.),50 the bankruptcy court authorized an in-kind distribution of equity instruments — rather than cash — to the first-lien lenders in the context of a § 363 sale in satisfaction of their claims. The bankruptcy court found that the underlying credit agreements anticipated the possibility that the first-lien lender’s secured claims could be satisfied by something other than cash. The district court, on appeal, reversed the decision and held that neither the intercreditor agreement nor the adequate protection provisions of the Bankruptcy Code authorized the satisfaction of the first-lien lender’s claim through an inkind distribution of securities in lieu of cash in the context of a sale outside of a plan.51 CONCLUSION The expansion in second-lien financings in recent years increases the likelihood that issues will arise in intercreditor agreements with increasing frequency and that those issues will require resolution in the courts. To date, only a handful of reported decisions address bankruptcy provisions, and existing case law does not provide a definitive set of rules. It is important for lenders and lawyers to recognize that it will be difficult to predict whether all terms of a subordination agreement will be enforced in a particular bankruptcy case. Some courts will construe the term “subordination” in § 510(a) of the Bankruptcy Code narrowly (to apply only to priority of payment) and refuse to enforce certain commonly negotiated protections, while other courts will tend to construe the term more broadly (to include the myriad elements of subordination included in most comprehensive intercreditor agreements). So far, it appears that courts focusing on the principle that the 218 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING provisions of an intercreditor agreement may not undermine specific provisions and policies of the Bankruptcy Code tend to construe “subordination” narrowly, whereas courts focusing on the enforceability of otherwise valid pre-petition subordination agreements tend to interpret the term more broadly. Lenders and lawyers should also understand that ambiguity in the credit documents and intercreditor agreements in any form can lend itself to varying interpretations and results.52 NOTES Hardwicke v. Hamilton, 26 S.W. 342, 345 (Mo. 1894). The total second-lien issuance for the 2006 calendar year has been estimated by Reuters Loan Pricing Corporation at $29.7 billion, up nearly 36 percent from 2005. Fitch Ratings, The Evolution of the U.S. Second-Lien Leveraged Loan Market — 2006 Year-End Update, at 1. (Jan. 17, 2007). This form of financing comprised approximately eight percent of the total institutional debt issuance in 2006. Id. Most sources believe that the second-lien market in 2007 has easily eclipsed previous statistics. 3 In a true second-lien structure, the first-lien lender is secured by substantially all the assets of the borrower and another lender is secured by a second-lien position in the same assets. It is not, however, uncommon in transactions for the second-lien debt holder to in fact have a first lien on certain assets, such as general intangibles and fixed assets, while the senior working capital lender takes a first lien on inventory, receivables and certain related assets, and a second position in all other assets. 4 The terms of intercreditor agreements and outcome of negotiations is driven by a number of factors, including (1) the identity and sophistication of the second-lien lender (whether a private equity fund, investment bank, hedge fund, affiliate or insider of the debtor, etc.), (2) the existence of prior transactions between the first and second-lien lender, (3) the relative size of the loans, (4) the nature of the firstlien lender’s loans (whether cash flow or asset-based), (5) the intended use of the proceeds provided by the second-lien lender (whether to pay down existing bank debt, cure defaults, provide additional working capital, fund expansion or effect a dividend to shareholders), (6) the experience and sophistication of the loan officers, attorneys and other professionals involved in the transaction, (7) timing issues (whether the second-lien financing is being structured in conjunction with or after the first-lien loan), (8) the urgency of the debtor’s need for capital and availability of alternatives, and (9) the investment approach and tolerance of the lenders. C. Edward Dobbs, Negotiating Points in Second Lien Financing Transactions, 4 DEPAUL BUS. & COM. 1 2 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 219 BANKING LAW JOURNAL L.J. 189, 191 (2006). 5 The essential purpose of intercreditor or subordination agreements is for one or more creditors to provide certain protections for the benefit of another creditor or group of creditors in the event of a default by or the bankruptcy of the common debtor. Subordination arrangements can be analogized to limited guaranty arrangements since the essence of an intercreditor agreement is a guaranty or indemnification by the junior creditor for the benefit of the senior creditor of amounts payable or received in bankruptcy or otherwise in contravention of the agreement. James L. Lopes, Contractual Subordination and Bankruptcy, 97 BANKING L.J. 204, 227 (1980). 6 Pepper v. Litton, 308 U.S. 295, 208 (1938). 7 11 U.S.C. § 510(c) (2006) (providing that the court may “under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim….”). Equitable subordination is typically appropriate if (1) the creditor engaged in inequitable conduct, (2) the inequitable conduct resulted in injury to creditors or conferred an unfair advantage, and (3) the subordination would not be inconsistent with bankruptcy law. See In re Clark Pipe & Supply Co., 893 F.2d 693 (5th Cir. 1990). 8 Second-lien lenders may seek to limit or eliminate some of these “add-on” items to the negotiated dollar cap on senior debt. For instance, subordinated lenders challenging “add-ons” frequently take particular issue with the inclusion of enforcement expenses, indemnity obligations and default interest as priority debt. Senior lenders typically insist that even if the amounts owing by the borrower exceeds the negotiated cap, the debt nevertheless remains secured by the collateral and is subject at least to a waterfall provision in the intercreditor agreement that allocates collateral proceeds between the lenders. Careful drafting of provisions in intercreditor agreements that cap or limit the senior debt is necessary in order to avoid the loss of senior lien status since the incurrence or accrual of non-advanced amounts under the senior facility could otherwise cause the aggregate debt owed to the senior lender to exceed the dollar cap. 9 Senior lenders often view indebtedness owed by the borrower to an insider or affiliate (or former insider or affiliate) to be equivalent to equity in terms of legal status and priority (e.g.,“seller paper” given by the borrower as consideration for some or all of the purchase price of a business). Under such circumstances, there is often very little room for the subordinated creditor to negotiate many of the terms of the intercreditor agreement. 10 Junior lenders frequently attempt to differentiate between payment defaults and covenant defaults. 11 Intercreditor agreements also typically preclude the junior lender from receiving any payments and require the junior lender to disgorge or turn over any payments 220 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING received (whether from the debtor or any other party on behalf of the debtor or the bankruptcy estate) during a specified period. 12 See supra discussing “standstill” and “standby” periods. 13 Since the expiration of the blockage period may force the first-lien lender to initiate action or risk losing the exclusive right to exercise remedies with respect to the collateral, borrowers have a similar interest in a longer blockage period. 14 The intercreditor arrangement should, particularly from the senior lender’s perspective, address financing provided to the borrower/debtor-in-possession during the course of a Chapter 11 bankruptcy proceeding, referred to in bankruptcy parlance as DIP financing. 15 See discussion “Caps on Senior Debt.” 16 Intercreditor agreements typically provide that the arrangement as between the lenders will nevertheless be given effect even if the lien is avoided or not perfected. 17 At the heart of any intercreditor arrangement is the specific agreement of the second-lien lender to subordinate its right to exercise its remedies. The first-lien lender’s exclusive right to address defaults and preclude lien enforcement by the subordinated lender is the hallmark of the “silent” second-lien financing structure. 18 See supra discussing customary periods and indicating that it is common for standstill periods to be coextensive with payment blockage periods. 19 See, e.g., 11 U.S.C. § 362 (2006). As a practical matter, the existence of a senior lien on the collateral significantly hampers the ability of the second-lien lender to dispose of collateral since any purchasers would take subject to the pre-existing and continuing lien. See generally, U.C.C. §§ 9-315, 9-617. 20 Article 9 of the Uniform Commercial Code provides that certain obligations imposed on first-lien lenders may not be waived in advance, including the following: (1) requiring notification to second-lien lenders prior to disposing of the collateral, (2) requiring all aspects of the collateral disposition to be commercially reasonable, and (3) certain rights of the second-lien lender to object to strict foreclosure of the collateral. See UCC §§ 9-602, 9-620. See also UCC § 9-625 (subjecting the firstlien lender to damages for breach of the obligations imposed under Article 9). 21 See, e.g., In re Ionosphere Clubs, Inc., 134 B.R. 528 (Bankr. S.D.N.Y. 1991). 22 A second-lien lender will frequently argue during the course of negotiations of bankruptcy provisions that restrictions in the intercreditor agreement should not be so severe as to place the lender in a worse position than it would occupy if it was a general unsecured creditor. 23 See generally, 11 U.S.C. §§ 361, 363 (2006). 24 See generally, 11 U.S.C. § 364 (2006). 25 A second-lien lender, in its attempt to avoid subordination, may attempt to arrange a DIP financing facility through affiliates or fund participants. Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 221 BANKING LAW JOURNAL See 11 U.S.C. § 362 (2006). See supra “Rule of Explicitness.” 28 See generally, Daniel J. Carregher, Sales Fee and Clear: Limits on § 363(f ) Sales, 26 AM. BANKR. INST. J. 16 (Aug. 2007) (addressing the ability of a debtor in bankruptcy to sell property in a § 363(f ) sale for less than the face amount of the secured debt absent the consent of all the lienholders). 29 11 U.S.C. § 510(b) (2006). Article 9 of the Uniform Commercial Code makes it clear that a creditor entitled to priority may effectively subordinate its claim by contract. See U.C.C. § 9-339 & cmt. 2. Section 1-310 of the UCC similarly provides as follows: An obligation may be issued as subordinated to performance of another obligation of the person obligated, or a creditor may subordinate its right to performance of an obligation by agreement with either the person obligated or another creditor of the person obligated. Subordination does not create a security interest as against either the common debtor or a subordinated creditor. Id. § 1-310; see U.C.C. § 1-310 cmt. 2 (stating that “[s]ubordination agreements are enforceable between the parties as contracts.”). 30 See H.R. REP. NO. 595, 95th Cong., 1st Sess. 359 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6315; S. REP. NO. 989, 95th Cong., 2d Sess. 74 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5860. See also 11 U.S.C. § 1129(a)(1) (rendering the confirmation standards of § 1129(b)(1) applicable “[n]otwithstanding section 510(a)”). Prior to the enactment of the Bankruptcy Code, subordination agreements were enforced through the bankruptcy court’s equitable powers since there was no specific provision addressing these arrangements. See, e.g., Bankers Life Co. v. Manufacturers Hanover Trust Co. (In re Kingsboro Mortg. Corp.), 514 F.2d 400 (2d Cir. 1975) (per curiam). 31 Compare In re Excelsior Henderson Motorcycle Mfg. Co., 273 B.R. 920, 924 (Bankr. S.D. Fla. 2002), In re Club Tower, L.P., 138 B.R. 307, 312 (Bankr. N.D. Ga. 1991) (enforcing pre-petition stay waivers), with Maritime Elec. Co. v. United Jersey Bank, 959 F.2d 1194, 1204 (3d Cir. 1991) (refusing to enforce pre-petition stay waivers). 32 Provisions in intercreditor agreements that impact the ability of the second-lien lender to provide post-petition DIP financing (perhaps on more favorable terms than that which may be offered by the first-lien lender) may be an exception. 33 The unprecedented infusion of debt and second-lien financing arrangements over the last five years (see supra note 2) will undoubtedly require bankruptcy courts to address intercreditor arrangements with increasing frequency. 34 5 B.R. 734 (Bankr. D. Minn. 1980). 35 Beatrice Foods Co. v. Hart Ski Mfg. Co., 5 B.R. 734, 736 (Bankr. D. Minn. 1980). 36 Id. Accord In re Hinderliter Indus., Inc., 228 B.R. 848, 850 (Bankr. E.D. Tex. 26 27 222 Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. THE LENDER’S GUIDE TO SECOND-LIEN FINANCING 1999) (“The intent of § 510(a) (subordination) is to allow the consensual and contractual priority of payment to be maintained between creditors among themselves in a bankruptcy proceeding. There is no indication that Congress intended to allow creditors to alter, by subordination agreement, the bankruptcy laws unrelated to distribution of assets.”). 37 246 B.R. 325 (Bankr. N.D. Ill. 2000). 38 Bank of America v. North LaSalle Street Ltd. Partnership (In re 203 North LaSalle Ltd. Partnership), 246 B.R. 325, 332 (Bankr. N.D. Ill. 2000). 39 1994 WL 646176 (E.D. La. 1994). 40 In re Winter Urban Broadcasting of Cincinnati, Inc., 1994 WL 646176 (E.D. La. 1994). Accord In re Curtis Ctr. Ltd. Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996); In re Itemlab, Inc., 197 F. Supp. 194 (E.D.N.Y. 1961); In re Davis Broadcasting, Inc., 169 B.R. 229 (M.D. Ga. 1994); In re Southland Corp., 124 B.R. 211 (Bankr. N.D. Tex. 1991). 41 362 B.R. 43 (Bankr. N.D. Ga. 2006) (addressing voting waivers and squarely addressing the contrary decision of the court in LaSalle, supra). 42 BKY Case No. 04-02817 (Bankr. M.D. Pa. May 10, 2004). 43 In re New World Pasta Co., BKY Case No. 04-02817, 2004 WL 1484987, at *2. 44 BKY Case No. 05-20022 (Bankr. D. Del. Nov. 7, 2005) (Walsh, J.). 45 See Mark N. Berman & Jo Ann J. Brighton, Part II: Anecdotes and Speculation — the Good, the Bad, and the Ugly, 25 AM. BANKR. INST. J. 24 (March 2006). 46 See In re Time Sales Finance Corp., 491 F.2d 841 (3d Cir. 1974). 47 See, e.g., In re Ionosphere, 134 B.R. at 533-34 (finding that the rule of explicitness survived the enactment of the Bankruptcy Code). 48 364 F.3d 355 (1st Cir. 2004). 49 Accord Chemical Bank v. First Trust of New York (In re Southeast Banking Corp.), 156 F.3d 1114 (11th Cir. 1998). 50 333 B.R. 30 (S.D.N.Y. 2005). 51 In re Westpoint Stevens, Inc., 333 B.R. at 49-50. 52 Following a common-debtor’s default, second-lien lenders can be expected to actively seek opportunities to challenge perceived defects in the intercreditor documentation and raise issues regarding enforceability under bankruptcy law in order to improve their positions. Published in the March 2008 issue of The Banking Law Journal. Copyright ALEXeSOLUTIONS, INC. 223
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