Second-Lien Financings Enforcement of Intercreditor Agreements in Bankruptcy1 Part I More Questions than Answers
Bankruptcy court decisions made in the early days of a chapter 11 case, when many of the intercreditor agreement provisions have their applicability, seldom result in written opinions. Further, the impact of the uncertainty regarding enforcement of the bankruptcy provisions in intercreditor agreements often results in a negotiated resolution between the first and second lienholders entered into prior to the bankruptcy case. Although the differing views on enforceability may impact the ultimate terms negotiated as between the first and second lienholders, there is no opportunity for the bankruptcy court, or others in the bankruptcy process, to present these issues to a bankruptcy court for determination. As a result, we believe that it will be helpful to present the limited anecdotal information that is available about second-lien financings where the borrower has now filed a bankruptcy case. Part II of this article (to be published in the March 2006 ABI Journal) will identify a sampling of those cases and describe the ways that the bankruptcy provisions in the intercreditor agreement applicable to each case had an impact (if at all) on the ultimate outcome.
Part I of this article will discuss the “disconnect” that currently exists between those negotiating the provisions concerning bankruptcy in the intercreditor agreement and any understanding as to exactly how those provisions will play out should a bankruptcy filing take place and, rather than provide practice points or clear answers, highlight some of the questions or possible “mine fields” in this area that are subject to interpretation and future adjudication. This list is not intended to be exhaustive, but rather thought-provoking for those of us who deal with working out second-lien transactions. The list may also provide a basis for discussion with the “front end” side of the firm or with lending clients.2
Second-lien financings have been growing rapidly in amount and number of transactions since 2002.3 Borrowers have been attracted to second-lien financings because of the lower cost as compared to mezzanine or high-yield debt. Borrowers are also looking for second-lien money to satisfy borrowing needs that cannot or will not be met by first lienholders. As a result, there has been a shift in “leverage” such that second lienholders have more negotiating power than when the second-lien market initially began to develop as a place for a short-term loan intended to bridge a time period after confirmation of a reorganization plan or to provide seasonal funds to a business. As a result of their growing market power, second-lien lenders have been able to improve their lot by moving the market terms of many intercreditor provisions. For example, standstill periods that started out in the early days of second-lien financings as unlimited in duration have shifted to a currently acceptable market standard of between 90-180 days. Further, second-lien lenders are less likely to agree to blanket waivers of bankruptcy rights than were originally expected by first lienholders. Another major change is that with the increased volume and popularity of second liens, full collateral coverage for both the first- and second-lien debt no longer appears to be an absolute precondition of such financing.4
Even though the growing list of bankruptcy-related provisions in inter-creditor agreements reflects the parties’ recognition that bankruptcy is a forseeable event, many of the parties negotiating first- and second-lien documents may not understand that the contractual bankruptcy provisions in the intercreditor agreement may not necessarily be enforced by the bankruptcy court. As a result, while these provisions are intended to produce predictability of results in a bankruptcy proceeding, the reality is anything but a certain path. It is our experience that the commonly negotiated provisions are driven by what is acceptable and saleable in the market, rather than by any sound understanding of how the provisions will play out in a bankruptcy case.
Bankruptcy professionals understand that the practical realities of the bankruptcy forum inevitably change possible future anticipated actions due to time constraints and, in many cases, rapidly dissipating asset value. The other “overlay” that must be considered, but which may not be fully understood by those negotiating these documents, is that the tension between the public policy behind our country’s bankruptcy laws and the plain meaning of the statutory priority scheme of the Bankruptcy Code will often come into conflict with the contract entered into by the two creditor groups (i.e., the first and second lienholders who seek in the intercreditor agreement to impact and alter that statutory scheme). Remember: When the loan transactions are entered into, there are only three parties (or groups of parties): the first lienholder, the second lienholder and the borrower. After a bankruptcy filing, there are many more: first lienholder, second lienholder, debtor/borrower, bankruptcy judge, creditors’ committee, U.S. Trustee, unsecured creditors, bondholders, equity, etc.
Potholes and Pitfalls?
What follows is a list of the issues that might be presented to bankruptcy courts about the enforceability of provisions commonly found in inter-creditor agreements used in second-lien financing transactions. We caution that the list is not exhaustive. However, it is intended to begin the discussion and to add to the open issues identified in our prior writings on this subject that have been referenced in Footnote 1, as well as to provoke thought concerning these, and the no doubt countless other, issues second-lien financings present.
1. Raising Objections
• Even if the second lienholders agree in the
intercreditor agreement to waive their right to object to a variety of
matters that might arise in a bankruptcy case, e.g., a sale of
substantially all assets free and clear of the second lien
holders’ lien or the terms of a debtor-in-possession (DIP)
credit facility proposed by the debtor and the first lienholders, what
stops the second lienholders from objecting anyway?
• Presumably, the first lienholder would move to strike the objection on the basis that the second lienholder agreed not to raise it. However, once the objection is raised, even if it cannot be pursued by the second lienholder, is it likely that the court will not consider what was said in the objection?
• Can’t many of the same objections be raised by the unsecured creditors’ committee or the U.S. Trustee?
• Might a bankruptcy judge choose to hear the second lienholders’ objection in the context of the bankruptcy and let the issue of the enforceability of the waiver in the intercreditor agreement be heard and ultimately resolved in a nonbankruptcy court somewhere and at some time in the future? Alternatively, might a bankruptcy judge strike the objection based on the presumed enforceability of the intercreditor agreement requiring the second lienholder to go to a non-bankruptcy court for a determination as to whether the waiver is enforceable? (Of course, by the time the issue is heard in state court, the bankruptcy objection would likely be moot).
• Does the bankruptcy court have the requisite jurisdiction to rule on the enforceability of provisions in the intercreditor agreement because it is “related to” the bankruptcy case or “affects the administration” of the bankruptcy estate, or is it simply a dispute between two nondebtors that is outside of a bankruptcy court’s jurisdiction?
• Will specific performance of the bankruptcy terms of an intercreditor agreement be available as a remedy to the first lienholders?
• What is the measure of damages for breach of the intercreditor agreement?
2. DIP Credit Facilities
• Should the
amount of priming DIP loans to be provided by the first lienholders be
counted against the senior debt cap sometimes included in the
intercreditor agreement as a restriction against more debt coming ahead
of the second lienholders? If it is, won’t this cause first
lienholders to consider lining up a DIP for the borrower using a
surrogate DIP lender?
• Assuming the priming DIP is in the best interests of the debtor and unsecured creditors, and assuming the interests of the second lienholders can be adequately protected, should a bankruptcy court consider the use of a senior debt cap as violative of bankruptcy public policy?
• Is it likewise against bankruptcy public policy to prohibit second lien-holders, by the terms of the intercreditor agreement, from extending DIP financing on better terms than the first lienholders can, or are willing to, extend?
• Should first lienholders be permitted to include an affirmation of the validity and enforceability of the intercreditor agreement in the DIP credit facility order (which, of course, is accompanied by a voluminous motion and which itself may be an enormous document to read)? Assuming such a provision is to be permitted, should local rules require the provision to be highlighted, or might they make many other provocative provisions?
• If such a provision is permitted, and if the bankruptcy court signs the DIP financing order with such an affirmation, is the court later prohibited from revisiting some of the provisions in the intercreditor agreement that may violate bankruptcy public policy (e.g., a waiver by the second lienholders of their right to vote on a reorganization plan)? In other words, does the first lienholders’ reliance on the DIP order in extending the DIP facility trump bankruptcy public policy?
• If the intercreditor agreement
contains no waiver by the second lienholders of the right to file a
reorganization plan (and even if there is), what prevents a second
lienholder from filing a plan (and if it does not, then a
creditors’ committee) that crams down the first lienholders such
that the first-lien debt will be paid over a period of years at a Till
• If so, and if the plan does not provide otherwise, what are the terms of the crammed down first-lien debt?
• If the holders of the first- and
second-lien debt were the same parties at inception, or become the
same parties through the trading of bank syndicate claims over time,
should the two obligations be collapsed into one class for the
purposes of plan classification, post-petition interest, etc.? After
all, even if there are two sets of loan documents, isn’t that
really just an agreement between two nondebtor parties that should not
bind the court from treating similar claims similarly?
• Is the decision on classification affected by whether the collateral agent for the first- and second-lien holders is the same party?
5. Officers of the Court and the Duty of Candor
• If the second
lienholder agrees not to object to the validity, extent, perfection
and priority of the first lien, but is aware of a perfection problem
with the first lien, does the attorney for the second lienholder have a
duty to the bankruptcy court to apprise it of the issue?
• Assuming the same set of facts, what if the DIP facility is a roll-up of the first lien—could the failure to advise the court of a defect in the first lien be considered a fraud on the court?
6. Fraudulent Transfers
• Are there fraudulent-conveyance issues lurking if, at the outset of the lending transaction, there was no value in the collateral to reach the second-lien debt, rendering it unsecured?
• Is there any risk that second-lien debt can be recharacterized as equity rather than unsecured debt if collateral value sufficient to cover the amount of the second lien and sufficient cash flow are not there at the outset of the loan? After all, repayment of the second-lien debt would be entirely conditioned upon the future performance of the borrower and, in a sense, the second-lien holders are sharing in the risk of the future performance of the borrower, just like equity.
8. Exposure to Claims of Unsecured Creditors
• In the context
of the refinancing of a troubled borrower with a second-lien
financing, might the second lienholders (not to mention the officers and
directors of the borrower) be at risk for claims being made against
them relating to the deepening insolvency of the borrower? Is there a
lender-liability concern based on an allegation that the second
lienholders should not have lent money in the first place?
• Could there be claims raised against the first and/or second lienholders that they aided and abetted in the breach of the principals’ fiduciary duties by allowing them to take on more debt than the borrower could possibly repay and thereby causing harm to the unsecured creditors (or equity) for which those creditors are entitled to be compensated? What if the first lienholders extend the second-lien debt to repay a portion of the first-lien obligation?
9. The Role of the Other Parties Involved in Bankruptcy Cases
• Are these, and other issues previously highlighted in prior writings, issues that exist just between the first and second lienholders? Does the debtor, U.S. Trustee, creditors’ committee, equity or the bankruptcy court have a right to be heard on these issues, and do they care how these issues get resolved?
We will answer the last question with our opinion, but leave the other issues open for thought (and resolution by a bankruptcy judge in the future). It appears that the issues surrounding the enforcement of the provisions in the intercreditor agreement impact more than simply the first and second lienholders. If the intercreditor agreement bankruptcy provisions make it impossible for the debtor to secure DIP financing, the case could convert before the debtor ever has a chance to reorganize or sell off its assets in an orderly way intended to realize going-concern value. The loser may in the first instance be the second-lien lender, but the unsecured creditors also lose the ability to negotiate over what they might receive by way of a “give-up” or for their cooperation in a reorganization plan. While the intercreditor agreement is a contract between nondebtor parties, some of the bankruptcy provisions have the effect of “contracting away” certain statutorily afforded rights under the Code, and therefore impact the delicately balanced mechanism for the conduct of bankruptcy cases and the negotiations that take place in those cases. Further, it is easy to see how the outcome of many of these disputes would ultimately affect the administration of the bankruptcy estate and thereby be of concern to the U.S. Trustee or the court.
Ultimately, the question of whether bankruptcy provisions in intercreditor agreements are enforceable may come down to a bankruptcy court’s determination of what exactly is a “subordination agreement” and, assuming an intercreditor agreement is a subordination agreement, which of its provisions are entitled to be enforced by §510(a) of the Code—purely payment subordination, or much more? In the end, as this growing area further evolves, more questions than answers continue to develop.
Stay tuned for Part II next month and an anecdotal discussion of recent cases where second-lien financings have hit the bankruptcy courts, and how these issues have played out to the benefit or disadvantage of the parties.
1 This article is the
product of a panel discussion on “Second Lien Financings”
presented at the 2005 ABI Winter Leadership Conference in Indian Wells,
Calif., on Dec. 2, 2005. The authors, together with Judge Judith
Fitzgerald, presented the topic for discussion at the meeting of
ABI’s Banking and Finance Committee. Both during and after the
discussion, questions were raised regarding the enforceability of many
of the bankruptcy provisions of intercreditor agreements that are
routinely entered into by and between first and second lienholders. We
thought it would be helpful to the bankruptcy community at large if
these questions could be exposed to a wider audience. For more
information concerning second-lien financings and questions concerning
the enforceability of provisions applicable to bankruptcy cases and
commonly included in intercreditor agreements associated with
second-lien financings, see Brighton, “Silent Second-Lien
Financings: Popular Lending Structure May Give Rise to Enforcement
Problems—Part 1: What Is Silent Second-Lien Financing?”
ABI Journal, February 2005 at 22; and Brighton,
“Silent Second-Lien Financings—Part II: Are They
Enforceable?” ABI Journal, March 2005 at 22. In addition,
see Berman, “Bankruptcy Public Policy and Implications for
Second-Lien Financings” published in the ABI WLCEducational
Materials, available at www.abiworld.org/abistore.
2 It is not our intent to take all the credit for many of these questions raised; much food for thought was generated by discussions with Judge Fitzgerald as well as the many lawyers in attendance at ABI’s 2005 Winter Leadership Conference. Further, Jo Ann’s colleague J. Michael Booe at Kennedy Covington provided his thoughts and opinions and was an instrumental sounding board in further developing these questions.
3 See “Second Lien Loans Blossom,” Standard & Poors Leveraged Commentary & Data.
4 See Batty and Brighton, “Silent Second Liens: Will the Bankruptcy Courts Keep the Peace?,” N.C. Banking Institute Journal, April 2005.