Second-Lien Financing Part V Who Gets What
WestPoint Stevens Inc. and its affiliates entered the chapter 11 world burdened with first- and second-lien debt. Unable to reach agreement with their creditor constituencies over the terms of a consensual reorganization plan and unable to refinance or otherwise restructure the DIP credit facility, the debtors decided to proceed with a §363 sale of all of their assets. The initial bid was put forward by a sub-group of the first-lien lenders led by Wilbur Ross, Jr. A competing bid was put forward by Carl Icahn, who held a majority of the second-lien debt and a minority of the first-lien debt. The Icahn bid prevailed, and the bankruptcy court entered a sale order authorizing the debtors' assets to be sold free and clear of liens. However, the Icahn bid and the resultant sale order were by no means your run-of-the-mill sale documents. Rather, while the bid included a substantial amount of cash and the assumption of substantial liabilities, it also proposed that a portion of the purchase price was to be paid in the form of unregistered equity securities and unregistered subscription rights to the stock of the acquirer's parent corporation. The cash was earmarked to pay down the DIP credit facility and the equity securities, and subscription rights were to be distributed to the first- and second-lien lenders. However, this is where it gets interesting: The Ichan bid required that the equity securities and subscription rights be valued, that the first- and second-lien lenders' claims be fixed in amount and that the equity securities and subscription rights be distributed to the two lender groups such that the first-lien lenders' secured claims would be fully satisfied by their receipt of a portion of the equity securities and subscription rights (with a value as determined by the bankruptcy court) equal in amount to the first-lien lenders' allowed claims. The balance of the equity securities and subscription rights were to be distributed to the second-lien lenders on account of their secured claims.
As one might have expected, the first-lien lenders (other than the Icahn interests) and their agent bank objected to the proposal that the first-lien claims be satisfied with illiquid minority equity interests in the acquiror's parent. When the bankruptcy court overruled their objections and entered the sale order, they appealed. As a result of agreements reached prior to the district court's decision, the sale was closed, the liens held by the first- and second-lien lenders were transferred to the equity securities that comprised part of the purchase price, and those equity securities were being held in escrow.
Bankruptcy Court Analysis
The first-lien lenders' credit agreement contained the usual provisions requiring that the debtors make payments to the first-lien lenders in cash or immediately available funds. It also provided that "amounts" collected after an event of default were to be distributed first to the first-lien lenders, and then any surplus to whomever was entitled by law. The intercreditor agreement permitted distributions to the second-lien lenders in limited circumstances. There were provisions for "Permitted Mandatory Pre-payments," "Adequate Protection" payments and "Payments to be Made Pursuant to a Confirmed Plan of Reorganization." Finding the use of the word "amounts" rather than "cash" significant, and noting that the relevant clause using the word "amounts" was introduced by the words "notwithstanding any other provisions of this credit agreement," the bankruptcy court found that the documents anticipated the possibility that the first-lien lenders' secured claims could be satisfied by something other than cash and permitted those claims to be paid in full by an in-kind distribution of equity securities valued in an amount equal to the allowed amount of the first-lien claims, with the balance of the sale consideration distributed to the second-lien lenders.
District Court Analysis
In reversing the opinion of the bankruptcy court, the district court emphasized that the bankruptcy court-ordered distribution of the sale proceeds to the first- and second-lien lenders was not being accomplished pursuant to a reorganization plan, but rather to a §363 sale order. The district court could find no authority in the Bankruptcy Code by which the bankruptcy court could order a secured creditor to accept an in-kind distribution over its objection and direct that the in-kind distribution satisfied the claims of the secured lender in full. Judge Swain also examined the first-lien credit agreement and the intercreditor agreement that had been entered into between the first- and second-lien lenders and rejected each of the arguments proffered by the second-lien lenders for why they could force an in-kind satisfaction of the first-lien lenders' secured claims.7
Interestingly, the district court looked to the terms of the same first-lien credit agreement and intercreditor agreement as had the bankruptcy court, but came to the opposite conclusion. In the district court's view, the documents did not authorize the distribution of any portion of the purchase price to the second-lien lenders until the first-lien lenders were paid in full and in cash. The use of the word "amounts" in the context of the first-lien credit agreement's discussion of how anything received after an event of default should be distributed did not suggest to the district court, as it had to the bankruptcy court, a willingness by the first-lien lenders to accept payment in any form other than cash. Further, while the lower court determined that the intercreditor agreement's "mandatory pre-payment provision" could be interpreted to authorize the distribution of stock to the first-lien lenders in satisfaction of their senior claims, the district court found that it was overridden by the credit agreement between WestPoint Stevens and the first lienholders.8 Moreover, while the intercreditor agreement contemplated that adequate protection payments could be distributed to the second-lien lenders, the district court could not find in §§362 or 363 of the Code any authority that would permit adequate protection to be utilized as a basis upon which to satisfy a senior leinholder's claims in-kind. Specifically, the district court stated:
The bankruptcy court pointed to no authority, nor has this court despite the extensive research efforts of counsel and the undersigned's own chambers found any, standing for the proposition that an action in permanent derogation of a senior creditor's contractual rights can be forced upon that creditor for the purpose of providing "adequate protection" to a junior creditor....
Taken to its logical extreme, the bankruptcy court's notion of adequate protection would allow a powerful creditor and a debtor anxious to achieve some value for its favored constituencies to run roughshod over disfavored creditors' rights...."9
The district court also rejected the bankruptcy court's reliance on the provision of the intercreditor agreement that permitted payments to the second-lien lenders pursuant to a confirmed plan. Quite simply, there was no confirmed plan in the case. Since the proposed distributions were being made under a §363 sale order, the district court concluded that the provision was not applicable to the facts in dispute.10
The district court also explored the statutory basis the bankruptcy court had utilized in entering the sale order, looking to §§363 and 105 to see whether the Code would permit the in-kind transfer of any of the purchase price to the second-lien lenders before the first-lien lenders were paid in full and in cash. In the district court's opinion, §363 provided no such authority. While §363 authorized the transfer of the debtors' property free and clear of liens, there was nothing in §363 that permitted the impairment of the rights of the first-lien lenders to be paid in cash. The district court noted that the provisions of §363 applicable to sales prior to a plan are not a substitute for the confirmation provisions of a plan in §1129. It also distinguished cases cited by the second-lien lenders as supporting the notion that secured creditors can be paid in full prior to confirmation of a plan by distributions received in the sale of estate assets. In the district court's opinion, the cited cases could not help the second-lien lenders here because the cases all involved distributions of cash while the attempt in this case was to satisfy the requirments in-kind and over the secured creditors' objection. The district court also gave little credence to the §105 argument because there was no provision of the Code that the §105 power was being employed to advance.11
In the end, the district court found that outside of the context of a plan confirmation and assuming such is required in the applicable credit agreement, a first-lien lender has a right to be paid in full and in cash before proceeds of its collateral can be disbursed over its objection to junior creditors. The district court remanded the case back to the bankruptcy court.12
What Is a Second-Lien Lender to Do?
It is axiomatic that in bankruptcy all things flow from value. If there is value in the collateral in excess of what is owed to the first-lien lenders, then second-lien lenders should be able to find a way to realize that value. However, when that value is represented by illiquid equity securities received in consideration of the sale of the collateral, there are obstacles to be overcome. Assuming there is true value in the illiquid equity securities over and above what is necessary to satisfy the administrative expenses of the case and to satisfy the claims of senior creditors, second-lien lenders can generally reach the value in the illiquid equity securities in one of three ways. First, if the collateral is sold, second-lien lenders should have their junior liens transferred to the proceeds as a form of adequate protection. The value of the junior interests in the collateral can be reached when those proceeds are ultimately distributed to creditors. The distribution can be effectuated by agreement of the parties via a chapter 7 case to which the chapter 11 is converted after the §363 sale has been concluded or through a liquidating chapter 11 plan.
Second, second-lien lenders can eschew a sale, perhaps having to resist efforts by the first-lien lenders to force one, and work to structure a liquidation or reorganization utilizing the rights afforded in §1129 of the Code. Either way, the second lienholders will have to undergo a valuation battle with the first-lien lenders. If the second lienholders opt for the reorganization, they may ultimately end up converting some or all of their junior lien claims into equity in the reorganized debtor and may require some additional investment by the second-lien lenders into the reorganized debtor. This route also poses the problem of what to do with unsecured creditors.
Third, it is not uncommon for an intercreditor agreement being negotiated in today's marketplace to afford the second-lien lenders the right to purchase the first-lien lenders' secured claims at par. Assuming there is value in the collateral beyond what is owed to the first-lien lenders and the second-lien lenders want to protect that value, purchasing the first-lien position may clear the way for the second-lien lenders to proceed in whatever way they believe is in their best interests.
Finally, keeping in mind the discussions contained in other articles in this series in the context of cases like Atkins Nutritionals and Maxim Crane, a consensual resolution, if possible, may be the best alternative for the first- and second lienholders. Second lienholders may be best served by using the leverage they possess based on their ability to slow down the chapter 11 process to negotiate for a consensual payment that they may not have received otherwise because the collateral value is insufficient.
The WestPoint Stevens chapter 11 cases present an interesting twist on these alternatives. The collateral is sold, but not for cash that can be easily distributed to the lienholders providing them with the value to which they are entitled. Instead, the purchase price is paid in an illiquid form—in these cases, in the form of equity of the parent of the acquiring entity. Based on the district court's decision, second-lien lenders do not have the option of forcing first-lien lenders to accept by way of distribution, at the time of the §363 sale, a portion of that purchase price and realizing the balance for themselves. Instead, they will either have to allow the illiquid equity to be sold and then see a distribution of the cash proceeds received over an above what is necessary to satisfy the first-lien lenders in full, or consider how to structure a reorganization plan/liquidation built around that illiquid equity.
Conclusion and Practical Lessons
The simple fact that the bankruptcy court and the district court reviewed the same provisions in the credit and intercreditor documents and then reached opposite conclusions serves as a lesson to first- and second lienholders to make sure that the negotiated deal between the parties is clearly drafted and consistent with other provisions in the underlying credit documents. Specifically, the bankruptcy court found language in the first-lien credit agreement and intercreditor agreement that it viewed as authorizing, in the context of a §363 sale, the satisfaction of a senior lender's secured claim with a portion of the purchase price composed of minority equity interests in an acquiring company and then the distribution of the balance of that purchase price to second-lien lenders. The district court reached the opposite conclusion viewing the exact same language. Accordingly, the business deal in the context of a bankruptcy liquidation must be clearly set forth at the time the documents are drafted and not considered for the first time when a bankruptcy is contemplated. As is true in all documentation interpretation and as is highlighted in these cases, ambiguity in any form can lend itself to varying interpretations and results. In the end, one clear lesson from the WestPoint cases is that the provisions of the underlying credit agreement cannot be inconsistent with those contained in the intercreditor agreement or, as the WestPoint cases highlight, the inter-creditor agreement may override specific provisions of the first-lien credit agreement (and arguably vice versa). Therefore, while first-lien lenders need to be careful in drafting the first-lien credit agreement and intercreditor agreement, and in harmonizing the two, second-lien lenders need to review the underlying first-lien credit agreement and consider the ramifications of its provisions on the negotiated deal between the parties as well.
1 Mark Berman's practice concentrates on bankruptcy law, workouts and commercial law. He is an active member of the Boston Bar Association, where he chaired its Bankruptcy Law Committee from 1990-92, served as chair of its Business Law Section from 1995-97, and where he currently serves as a member of its Bankruptcy Section's Steering Committee. Mr. Berman has taught courses in credit law and business law for the New England Institute for Credit from 1989-2002 and is currently a facilitator for those same courses taught online on behalf of the National Association of Credit Management. He served as a member of the Client Security Board for the Commonwealth of Massachusetts from 1997-2002 and is listed in Woodward and White's The Best Lawyers in America and in Chambers USA's America's Leading Attorneys for Business, each for his expertise in bankruptcy law.
2 Jo Ann Brighton practices primarily in the area of bankruptcy, workouts and secured lending. She is a co-chair of ABI's Business Reorganization Committee.
3 For the prior installments of this series, see Berman, Mark and Brighton, Jo Ann J., "Second-Lien Financing: More Questions than Answers," American Bankruptcy Institute Journal, Vol. XXV, No. 2 (February 2006); Berman, Mark and Brighton, Jo Ann J., "Second-Lien Financing Part II: Anecdotes: The Good, the Bad and the Very Ugly," American Bankruptcy Institute Journal, Vol. XXV, No. 2 (March 2006); Berman, Mark and Brighton, Jo Ann J., "Second-Lien Financing Part III Anecdotes: The Good, the Bad and the Very Ugly," American Bankruptcy Institute Journal, Vol. XXV, No. 4 (May 2006); Berman, Mark and Brighton, Jo Ann J., "Second-Lien Financing Part IV: Anecdotes: The Good, the Bad and the Very Ugly," American Bankruptcy Institute Journal, Vol. XXV, No. 4 (June 2006).
4 The cases are being jointly administered under docket #03-13532.
5 In re WestPoint Stevens Inc., 333 B.R. 30 (S,D.N.Y. 2005).
6 As we have with our other articles in this series, we have talked to some but not all of the parties active in the cases to try to understand what motivated them and their view of the other side's position or of the court's ruling. While we have tried to be accurate, but offer our sincere apologies if any of the information is inaccurate or if any of the motivations about which we speculate are misstated.
7 333 B.R. at 30.
8 333 B.R at 44-46. See, also, Dzikowski, "Battle of WestPoint," The Secured Debt Report, Vol. II, No. 10, May 21, 2006.
9 Id. at 49-50.
10 333 B.R. at 50-51.
11 Id. at 53-55.
12 It is the authors' understanding that the bankruptcy court has ordered that the illiquid equity securities of the parent of the acquiring company, until now held in escrow and impressed with the replacement liens of the first- and second-lien lenders, should now be sold at auction in a UCC foreclosure sale context. That decision has now found its way on appeal to Judge Swain.