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].
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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
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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-
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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
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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
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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
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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-
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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,
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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
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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.
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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
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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
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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
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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
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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).
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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
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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-
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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
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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-
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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
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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
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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
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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.
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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
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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.
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