This is the third installment in a series of articles that focus on the actual experiences realized when second-lien financings hit the bankruptcy courts. In the second installment printed in the March Journal, we explored the American Remanufacturers case.¹ This third installment explores the Atkins Nutritionals Inc., et al, chapter 11 cases. As a reminder, this report is purely anecdotal.² However, it is readily apparent that the comparisons with the first installment could not be more striking. Atkins resulted in a confirmed chapter 11 reorganization plan, a continuing business operation, and both first- and second-lien lenders participating in the reorganized company. By contrast, American Remanufacturers cratered at the very start—unable to resolve differences between the first- and second-lien lenders on the terms of the DIP credit facility. The case was converted to a chapter 7 liquidation and the assets sold by the chapter 7 trustee. In our view, nobody gained a thing by the battle over rights between the first- and second-lien holders contained in the intercreditor agreement.

Background and Workout

The Atkins story has its roots in 1972, when Dr. Atkins published his first book about low carbohydrate (low-carb) dieting. A second book on the same topic was published in the '90s and became a best-seller. Paralleling the publishing of second book, Dr. Atkins established a corporation that introduced a low-carb food product in 1997. More products followed, and as the low-carb diet became a significant force in American society, the company grew to meet a growing demand. In 2003, the company, Atkins Nutritionals, was acquired by Parthenon Capital Inc. and its affiliates along with Goldman Sachs Capital Partners and its affiliates. While the acquisition included a significant amount of equity put into the company by its new owners, it also included a significant credit facility in which UBS served as the agent for a syndicate of secured lenders. The credit facility involved a single credit agreement,3 and UBS served as the single collateral and administrative agent for two levels of secured debt. The first level was granted a first lien on substantially all assets of Atkins Nutritionals and its affiliates, while the second level was granted a second lien on those same assets. Each level was widely syndicated.

However, the low-carb diet revealed itself as a fad, and the growth of demand for Atkins Nutritionals cooled in 2004 as the company's performance was further hit by competitive products from established food manufacturers. Later in 2004, Atkins Nutritionals defaulted on its pre-petition credit agreement. A workout ensued.

During the workout, several things became apparent. First, the first-lien lenders could "control" the process by outvoting the second-lien lenders on those matters governed by the pre-petition credit agreement. As a result, declaring a default or taking enforcement actions that might be the subject of an intercreditor agreement and a resultant standstill period for the second-lien lenders were all in the control of the first-lien lenders, who dominated due to the size of the first-lien credit when compared to the second-lien credit.⁴

Second, there was a significant amount of cross-ownership of the first- and second-lien positions, so much so that it became difficult to find lenders who participated in only one of the positions and who would be willing to serve on a steering committee (a group often formed when a syndicated secured loan goes into default in order to make the process of negotiation and decision-making more streamlined). As a result, most lenders looked at the credit facility from a total-return standpoint rather than exclusively from the standpoint of the first- or second-lien position. This probably reduced the amount of friction between the two positions.

Third, many of the lenders who had acquired their positions via trading had a perception that their rights were different than the documentation revealed was true. Several first-lien lenders believed they enjoyed the benefits of debt subordination rather than only lien subordination. The "waterfall" provisions of the credit agreement addressed only distributions from collateral and not payments that the first- or second-lien lenders might obtain outside of collateral liquidation.

Fourth, the first-lien lenders generally favored a quick sale of the company where they could realize what they believed to be the current value of the company. The first-lien lenders believed that the liquidation of the company would result in less than payment in full of their first-lien position.

Fifth, the second-lien lenders generally wanted a chance to realize the value that might be created over and above the first-lien position if the company could be reorganized and proceed profitably into the future. While the second-lien lenders feared that a sale of the company would leave them with nothing, they also believed that with the benefit of the new management team and other operational changes, there was a realistic chance for a greater return down the road. Accordingly, the second-lien lenders believed that their collateral had real value if the business could continue as a going concern.

Sixth, none of the parties, or their advisors, were sure of how reorganization securities would be dealt with in a chapter 11 case (i.e., whether the equity to be issued in a chapter 11 reorganization would be considered the proceeds of the first- and second-lien lenders' collateral).

These forces resulted in the negotiation of a pre-bankruptcy lock-up agreement being entered into by the first- and second-lien lenders. The lock-up agreement contemplated a chapter 11 filing, a DIP credit facility geared to providing the debtor with sufficient funds to ensure operations during the chapter 11 process and a plan that would either allow the company to be reorganized with both first- and second-lien lenders sharing in the reorganized company, or a sale of the business should a reasonable good prospect appear.

The Chapter 11 Case

Atkins Nutritionals filed its chapter 11 case in the Southern District of New York on July 31, 2005. At that time, there was approximately $300 million in secured debt with $216 million held by the first-lien lenders and $84 million held by the second-lien lenders. Unsecured trade payables amounted to about $36 million. Of course, the debtor had the benefit of the pre-negotiated plan represented in the lock-up agreements between the first- and second-lien lenders. What remained was what would happen to general unsecured creditors who stood to get nothing based on the pre-negotiated deal.

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In any bankruptcy, dealing with limited assets expeditiously will always be more beneficial than standing on supposed contractual rights and litigating while the assets continue to decline in value.

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A series of first-day motions produced the expected result, and the DIP credit facility was approved by the bankruptcy court and put in place. No sale materialized, and the deal represented by the lock-up agreement was made the subject of the reorganization plan. As a result of the creditors' committee raising issues arising out of the 2004 acquisition and threatening litigation against the family of Dr. Atkins, a deal was reached that involved the Atkins family funding a 15 percent cash dividend for unsecured creditors in exchange for a release of all claims. First-lien lenders received the right to participate in a new $110 million post-petition credit facility secured by a first lien on all assets. The remainder of the first-lien debt, and all of the second-lien debt, was converted into equity in the reorganized debtor. Equity provided to second-lien lenders and management included special rights that acted like warrants if the value that could be derived from the business on a sale exceeded $115 million. A management-incentive plan was put in place providing not only for equity ownership, but also for bonuses upon the happening of certain events.

All told, assuming there is value in the stock of the reorganized company, the first-lien lenders received value equal to 100 percent of their claim plus the benefit of the pricing and participation in the DIP facility. They also secured the collateral to themselves alone should the post-chapter 11 operations falter and only liquidation value be realized. The second-lien position assuming an $18 million value on the reorganized company stock provided to them recovered value of approximately 20-25 percent.

The future fate of the reorganized company will bear out whether Atkins works out for the first- and second-lien lenders. Can it sustain a profitable operation? Will a sale of the business as a going concern be realized at greater than the $115 million price? It would appear at first blush that the second-lien lenders recovered more than they would have had the assets been liquidated in a chapter 7 case or even sold as a going concern in a §363 sale during the chapter 11 case. Ostensibly, any recovery for second-lien lenders must have been at the expense of the first-lien lenders.⁵ However, it is fair to say that the chapter 11 process worked smoothly. Employee jobs were saved. The first-lien lenders continue to earn interest on a reduced first-lien credit facility, both first- and second-lien lenders have a piece of the equity in the reorganized company, and unsecured creditors got an immediate cash dividend.

The more difficult question to answer is this: Why did Atkins work out this way (i.e., with a confirmed chapter 11 plan), when American Remanufacturers, having converted to chapter 7, did not? Were the polar opposite results a function of the Atkins credit facility utilizing a single credit agreement, a single security agreement and a single agent? Or was the negotiated-for result a function of Atkins having significant cross-ownership in the pools of first- and second-lien lenders so that the bank group as a whole was oriented to finding the best possible return on their investment in both pools rather than pushing one to the disadvantage of the other? In the end, one thing seems clear: In any bankruptcy, dealing with limited assets expeditiously will always be more beneficial than standing on supposed contractual rights and litigating while the assets continue to decline in value.

Stay tuned. Next month we will discuss two other recent bankruptcy cases that involved second-lien financing and the resultant inter-creditor issues—the New World Pasta, a.k.a. Ronzoni, and the Maxim Crane bankruptcy cases.

Footnotes

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

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 It has become more common for second-lien lenders to insist upon separate credit agreements with separate security agreements and UCC financing statements to document their secured loans with an inter-creditor agreement being negotiated between the two. See Kerr and Rovito, "Second Lien Evolution Creates Higher Recovery Prospects–At First Lien Lenders' Expense," Ratings Direct, Aug. 5, 2005.

4 The authors believe that most current second-lien financings documented today involve separate credit agreements for the first- and second-lien lenders. This approach enhances the likelihood that a bankruptcy court will view the two sets of lenders as holding separate loans rather than as participants in a single loan. This issue has ramifications for classification in chapter 11 plans as well as the right to accrue post-petition interest and adequate protection. As can be seen from the Atkins Nutritionals experience, it also has ramifications for the ability of the second-lien lenders to impact the workout and chapter 11 process. See In re Ionosphere Clubs Inc., et al, 134 B.R. 528 (S.D.N.Y. 1991).

5 See Kerr and Rovito, "Second Lien Evolution Creates Higher Recovery Prospects–At First-Lien Lenders' Expense," Ratings Direct, Aug. 5, 2005.