Part I of this article was published in the February issue. Our objective for that article was to provide supplemental information to previous articles on second-lien financing by relating some of the issues and questions raised at a panel presentation on this topic in which the authors and Hon. Judith Fitzgerald¹ participated at ABI's 2005 Winter Leadership Conference. As previously stated in those articles, there is little published case law addressing second-lien financing issues, or the enforceability of the many commonly included bankruptcy provisions in the intercreditor agreements that are a critical piece of the second-lien financing documentation. The authors have speculated that the dearth of case law is due in part to the time constraints with which the participants in many highly leveraged bankruptcies toil, and the resultant necessity to settle many of the issues amicably or otherwise, in the end, no party benefits.

Part II of this article begins with the first in a series of anecdotal reports² in which we will share with you experiences in recent chapter 11 cases that involve second-lien financings. We title these reports "The Good, the Bad and the Ugly," but leave it to the reader to decide in which category each case falls. In each of the cases, the parties and/or the bankruptcy court have had to wrestle with the impact of the first/second-lien structure and its impact on the reorganization or liquidation process and the likely interpretation or enforceability of provisions in the intercreditor agreements. Our hope is that by sharing this information, the parties and bankruptcy attorneys involved in future cases might be better prepared to deal with similar issues, or at least be forewarned as to what might happen if the issues are not successfully resolved.

We begin the series with the American Remanufactures case³ out of the U.S. Bankruptcy Court in Delaware and over which Hon. Peter Walsh presided. The case did not result in any written opinions that we are aware of, but is a fascinating example of what happens when the parties cannot reach a settlement. It appears to the authors that no one benefited by the parties' inability to resolve the intercreditor issues, although we leave readers to draw their own conclusions.

The Chapter 11 Case

American Remanufactures Inc., et al. (debtor) filed petitions for chapter 11 relief on Nov. 7, 2005. The debtor was a roll-up and employed 1,400 people. The debtor's first-lien credit facility was originally negotiated in March 2005, less than nine months prior to the chapter 11 case, and it included a revolver and term loan aggregating $50 million that was secured by substantially all of the debtor's assets. While it had not been involved when the first-lien credit facility had originally been negotiated and documented, at the time the petition for bankruptcy relief was filed, Black Diamond Commercial Finance LLC was the agent for the first lienholders and controlled that senior lien position. The second-lien credit facility involved a term loan of $40 million and was also secured by a junior lien on substantially all of the debtor's assets. At the start of the chapter 11 case, the second-lien position was controlled by DDJ Capital Management LLC, which also served as agent, and Airlie Opportunity Master Fund Ltd. The second lienholders also held a $4 million piece of the first-lien credit facility. As part of the first-day motions, the debtor asked the bankruptcy court to approve a $30 million DIP financing credit facility to be provided by the first lienholders. As a normal part of the first-/second-lien credit faculties' documentation, an intercreditor agreement existed and included the following provision:

Section 2.2. Lien Priority. Notwithstanding the date, manner or order of grant, attachment or perfection of any liens securing the second-lien obligations granted on the collateral or of any liens securing the first-lien obligations granted on the collateral and notwithstanding any provision of the Code or any applicable law or the second-lien credit documents, the second-lien agent, on behalf of itself and the other second-lien claimholders, hereby agrees that (a) any lien on the collateral securing any first-lien obligations now or hereafter held by or on behalf of the first-lien agent or any other first-lien claimholder or any agent or trustee therefore, regardless of how acquired, whether by grant, possession, statute, operation of law, subrogation or otherwise, shall be senior in all respects and prior to any lien on the collateral securing any of the second-lien obligations; and (b) any lien on the collateral now or hereafter held by or on behalf of the second-lien agent, any other second-lien claimholder or any other agent or trustee therefore regardless of how acquired, whether by grant, possession, statute, operation of law, subrogation or otherwise, shall be junior and subordinate in all respects to all liens on the collateral securing any first-lien obligations, provided that if the first-lien agent voluntarily agrees to subordinate any liens on any collateral securing the first-lien obligations to any liens securing obligations owing from the company or the other credit parties to any third party (other than liens expressly permitted under §6.7 of the first-lien credit agreement as in effect on the date of this agreement), then the provisions relating to the priority of liens and subordination of payments set forth herein shall not be effective with respect to the collateral which is the subject of the liens securing the first-lien obligations that were voluntarily made subordinate to the liens securing the obligations owing to third parties; provided further that the forgoing proviso shall not apply to any subordination of liens on any collateral securing the first-lien obligations to liens on such collateral securing other first-lien obligations. Except as provided in the provisos to the immediately-preceding sentence, all liens on the collateral securing any first-lien obligations shall be and remain senior in all respects and prior to all liens on the collateral securing any second-lien obligations for all purposes, whether or not such liens securing any first-lien obligations are subordinated to any lien securing any other obligation of ARI, the company, any other credit party or any other person (emphasis added).

The Intercreditor Agreement also included a cap on the total amount of first-lien obligations to which the second lien would be junior.

Prior to the chapter 11 filing, and not long after the first- and second-lien credit facilities were put in place, new management for the debtor arrived and announced that earnings for the prior year needed to be restated; the debtor was not performing to plan and was losing money. A short-term forbearance agreement was successfully negotiated that increased the revolver, but covenant problems arose, and the debtor was in default of the forbearance agreement just six weeks thereafter. The first-lien notes were trading at a discount to par.

When the chapter 11 case began, the debtor could not live on its own cash flow and therefore, like so many other chapter 11 debtors, needed a DIP credit facility. The debtor obtained offers for DIP credit facilities from both the first and second lienholders. The first lienholders would not consent to being primed by the DIP credit facility proposed by the second-lien lenders, and the second-lien lenders would not consent to being primed by the DIP credit facility proposed by the first-lien lenders. The debtor, believing that the first lienholders were undersecured and, therefore, the second lienholders were entirely unsecured, elected to proceed with the first lienholders' DIP proposal. Influencing that decision was the debtor's belief that it could not provide adequate protection to the first lienholders.

The DIP motion was heard by the court on Nov. 9, 2005 (i.e., the third day of the case). The DIP motion included, inter alia, tying the DIP credit facility to a quick sale of the debtor's assets with Black Diamond serving as the stalking horse. In connection with the DIP motion, the debtor presented the court with a liquidation analysis showing that there was no value in the collateral for the second lienholders and concluding that they were unsecured. The proposed DIP order included the following provision:

The imposition of the DIP liens, and any agreement or consent by the pre-petition senior agent and/or pre-petition senior lenders provided herein, does not violate or breach any provisions of the intercreditor agreement, nor does it affect, alter or otherwise modify the priorities between the pre-petition senior liens and pre-petition senior indebtedness on the one hand, and pre-petition junior liens and pre-petition junior indebtedness on the other hand, including, without limitation, as a result of §2.2 of the intercreditor agreement.

In response to the debtor's DIP motion, the second lienholders filed an objection identifying the following issues:

• Less expensive and less restrictive financing was available. Prior to the chapter 11 case being filed, the second lienholders had offered to provide a DIP credit facility on better credit terms (25 basis points less) than the DIP credit facility proposed by the debtor with the first lienholders and without the sale of assets requirement. Going with the second lienholders' DIP credit facility would, therefore, permit the case to go forward toward a normal reorganization rather than a quick sale.
• The proposed DIP facility required a quick liquidation of assets with the DIP lender serving as the stalking horse. Pre-petition, the second-lien lenders had submitted what they believed to be a better offer for the assets than the one the debtor proposed to make the stalking horse, but the debtor apparently rejected that offer because, as reported by the second-lien lenders, had the debtor accepted that offer, the debtor would not have been able to secure DIP financing.
• The DIP facility was a sub rosa plan because it required the immediate liquidation of the debtor' assets (i.e., within 75 days of the date the chapter 11 case had been filed) and altered the rights of the second lienholders by putting them in a position where any successful objection they might pursue to the proposed sale of all assets jeopardized the DIP credit facility.
• The DIP facility violated the intercreditor agreement by invalidating its §2.2. In the view of the second lienholders, §2.2 on the Intercreditor Agreement, coupled with the priming liens to be granted to the DIP lenders as part of the DIP credit facility without the consent of the second lienholders, would render the first lienholders' lien pari passu with that of the second lienholders.
• The DIP credit facility required priming liens without providing the second lienholders with adequate protection as required by §364(d) of the Code. In this context, the second lienholders took the position that the going concern value of the debtor's assets was higher than the liquidation value, and while the liquidation value might not produce anything to reach the second lien, the debtors had not met their burden of proof that the second lienholders were out of the money if the debtor's business were valued as a going concern.

The hearings on the DIP credit facility lasted for four days. No independent valuation expert testimony was presented by either party, although evidence was presented that the value of the collateral, even on a going concern basis, was insufficient to pay the first lienholders in full. In what it probably believed would set the stage for a negotiated resolution between the first and second lienholders, the court, in a preliminary ruling, decided that the proposed DIP credit facility triggered the proviso in §2.2 of the intercreditor agreement underlined above. However, it was not clear what result followed from triggering §2.2. The language of §2.2 states that if the underlined proviso is triggered, the lien priority provisions of the intercreditor agreement would not be effective as between the first and second lienholders. At first, the court ruled that should the DIP facility be approved while the DIP loan would have the benefit of a senior lien on all assets, the triggering of the underlined proviso meant that the first and second liens would share pari passu behind the DIP credit facility. However, at the request of the first lienholder, and although the transcript is not clear on this point, the court later seemed to back away from determining that pari passu status would result and left the door open to the argument that state law would determine the relative priority as between the first and second lienholders (i.e., the first to file would prevail). At this point, unwilling to risk losing the priority of its first lien, Black Diamond withdrew its offer of a DIP credit facility. This ruling was clearly a victory for the legal position advanced by the second lienholders that sought to prevent the first lienholders from controlling the chapter 11 case and forcing a sale process via the DIP credit facility. However, the victory was fleeting.

While the court and the debtor may have believed that a deal was there to be struck between the first and second lienholders, none was forthcoming. The first lienholder was adamant that it had senior rights in the collateral to those of the second-lien lenders, that there was no value for that junior position and that it would rather liquidate the collateral than share that value. From the vantage point of the second lienholders, there was simply no willingness of the first lienholders to negotiate. An offer by the second lienholders to buy out the first lienholders was rejected. With no DIP credit facility available, no way to break the impasse between the first and second lienholders, and running out of cash, the debtor moved to convert to chapter 7. When that conversion motion was granted, the operations were shut down and 1,400 employees were out of work. The liquidation was completed about 60 days later by a chapter 7 trustee who, in mid-January 2006, closed on a sale of all of the assets to one of the participants in the first-lien credit facility. No value is expected to be realized from the sale of the assets for the second lienholders or for unsecured creditors.

Who Wins?

An observer has opined that the first and second lienholders took out their guns and shot each other. From any perspective, it is hard to understand who won or who benefited by the result achieved in this case. Certainly not the debtor, which was closed and its assets sold by a chapter 7 trustee. The first lienholders don't appear to have achieved much as they will now receive the proceeds of a chapter 7 liquidation of their collateral realized after the business had been closed for 60 days, rather than benefiting from the higher reorganization value usually achieved in a successful reorganization or the going-concern value that can usually be realized by a sale of the ongoing business during the chapter 11 case. However, the first lienholders did achieve a rather quick liquidation of the assets, and didn't suffer the debtor's ongoing losses from operations or the continued legal costs associated with fighting with the second lienholders over every issue going forward in a chapter 11 case. In the words of one of the participants, at least the case was "mercifully short." The second lienholders seem not to have accomplished any monetary benefit for themselves, although they did win the legal argument over the interpretation of §2.2 of the intercreditor agreement. In addition, if they were out of the money when the case began based on a realistic valuation of their collateral, then they didn't lose anything by failing to reach an agreement. The second lienholders just failed to gain anything. Of course, whatever they paid to acquire the second-lien claims was lost, but that had already been lost when the chapter 11 case began. The unsecured creditors, owed over $22 million, are certainly not winners as they have no future business prospects with the debtor and will not receive anything on their unsecured claims unless the avoidance powers of the chapter 7 trustee produce recoveries. Accordingly, it's hard to conclude that the unsecured creditors are in a better place. Finally, the employees are out of their jobs, and those that don't catch on with the new owners are perhaps the biggest losers.

The question thus becomes: Did anyone win? Presumably, for the first lienholders, the answer depends on how they compare the value realized by the chapter 7 trustee's sale of the debtor's assets against what might have been realized in a chapter 11 going concern auction less whatever they might have had to pay the second lienholders to reach a settlement of the intercreditor issues. The second lienholders appear to have won the pyrrhic victory of the court's agreement with their interpretation of the language in §2.2 of the intercreditor agreement. However, it appears that both the first and second lienholders believe they achieved something—in the form of the message the case sends to those who will be involved with them in second-lien financing cases in the future. The first lienholders' message: "First lienholders are senior to second liens. We would rather risk realizing the depressed values of a chapter 7 liquidation than give to junior secured parties some of the value to which we are entitled." The second lienholders' message: "We're willing to lose it all rather than allow the first-lien lender to dictate all aspects of the chapter 11 process including control over the reorganization and sale processes." In other words, "if you don't play ball with us by either giving us a piece of the action or an opportunity to realize value through reorganization, then you'll suffer." Whether these messages have any real value to the parties involved will only be seen in the wake of that next case. Time will tell.

Could this case have turned out otherwise? Certainly. The secured parties could have reached some type of agreement over the DIP credit facility that would have resolved how asset value could have been shared in a chapter 11 sale or by way of a traditional reorganization. For whatever reason, such an agreement was not to be in this case. Perhaps there simply was not enough time to get to the promised land of a negotiated resolution. Alternatively, the court could have conducted a valuation hearing as part of the first-day hearing process. Had this resulted in a finding that the second lien was entirely out of the money, it is possible, although not assured, that the court could have concluded that the intercreditor agreement had no continued viability. It appears problematic whether there was adequate time to conduct such a hearing in the early days of the case, whether the court would even have been willing to do so, and what the testimony on value would have been. There is also the possibility that the second lienholders still had the right to insist upon the §2.2 result even in the face of a second lien unable to reach value in the collateral.

However, an important observation is in the language of the intercreditor agreement. As far as we are aware, although the concept at play in §2.2 (i.e., limits to the ability of the first lienholders to negotiate priming liens in DIP credit facilities) remains an expected piece of the intercreditor agreement negotiations, the actual language used in §2.2 employed in the American Remanufacturers' intercreditor agreement to accomplish that goal is not the norm for intercreditor agreements currently being negotiated in first- and second-lien credit facilities. While it is hazardous to define what "market" is at any given time, if a "market" in intercreditor-agreement terms in fact ever exists, the current norm appears to involve the interplay of several provisions. To begin with, first lienholders receive a blanket consent from second lienholders to impose priming liens in a DIP credit facility. To protect the second lienholders from an improvident DIP credit facility forced upon them by the first lienholders, this blanket consent to DIP credit facilities approved by the first lienholders is often coupled with a variety of limitations including one or more of (1) a cap on the amount of debt that can come ahead of the second lienholders in the priority structure, (2) a cap on the amount of the DIP credit facility or (3) a limitation on the features of a permitted DIP credit facility addressing provisions that dictate plan or sale terms. In addition, current forms of intercreditor agreements often allow the second lienholders to purchase the first lienholders' claims at par, although it is not clear that this would have resolved the problem with the American Remanufacturers' case because the second lienholders may have not been willing to pay par for the first-lien position. The first-lien position is understood to have been trading at a discount to par, meaning that the second lienholders would be paying more than market price to protect their second-lien position. However, in other distressed situations, the right to purchase a senior position at par might give second lienholders, who believe their second-lien position has value, a means by which to remove the impediment of a recalcitrant first lienholder.

Conclusion

So we will allow the readers to decide: good, bad or ugly? Regardless of the label, the American Remanufacturers case is significant for what did not happen—specifically, the inability of the parties to achieve a consensual settlement among the first- and second-lien lenders concerning disputes arising out of the terms of the intercreditor agreement. It also emphasizes two points made in Part I of this article. First, while many of the commonly included (and heavily negotiated) provisions in intercreditor agreements in second-lien transactions may not be enforceable, enforceability may not be worthwhile to litigate because time is short, resources are limited, the outcome is far from certain and the parties may not like the outcome even if you convince the court that your interpretation is correct. Second, when crafting the language of an intercreditor agreement or acquiring a secured position subject to such a document, it is essential that attorneys familiar with bankruptcy law and the reality of chapter 11 practice be consulted on the terms of the intercreditor agreement so that they can consider and advise clients on the impact of clauses that only have meaning in the context of a chapter 11 case.

Next month we will discuss another recent case that involved second liens and intercreditor issues, but that yielded quite different results—the Atkins Nutritionals chapter 11 case.

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Footnotes

¹ U.S. Bankruptcy Court for the Western District of Pennsylvania.

² The authors reviewed some, but not all, of the pleadings and spoke to some, but not all, of the parties involved in the case discussed in this article. Our sincere apologies if any information we report in this article is incorrect, or if the motivations we speculate about are inaccurate.

³ Delaware-Case no. 05-200022 (filed 11/7/05) (Judge Walsh).