Silent Second Lien Financings Popular Lending Structure May Give Rise to Enforcement Problems Part I What Is a Silent Second Lien Financing
Typical Structure of Silent Second Lien Loans
Over the past few years, a trend has developed toward the use of financing secured by second liens, both as an alternative to unsecured subordinated mezzanine financing and as a way to differentiate two classes of term loans within the same senior secured credit facility.2 The liens are generally referred to as "silent second liens" because the second lienholder often agrees to subordinate its rights and interests in pursuing its lien if there is a default.
Companies have a variety of options for structuring financing in a way that provides the most benefits for their particular businesses. With the changes in the financial markets over the past several years, more creativity has been brought to bear than ever before. Economic downturns have lasted longer than originally anticipated, and cash flow and collateral values have fallen drastically. Cash flow lending has, for all intents and purposes, essentially disappeared from the lending landscape and has not returned as expected. Traditional lenders are scrutinizing deals much more heavily and have imposed much stricter standards for terms on bank loans. The result has left many public and private companies in a quandary as to how to refinance their debt when a cash flow loan expires or bonds mature.3 One solution that has emerged is a traditional asset-based loan in conjunction with a second lien financing. In fact, the second lien market has expanded dramatically since 2003. One commentator reported that in 2003, the volume of second lien loans was $3.265 billion, and in 2004 (first through third quarters), it was $9.899 billion.
Second liens are being used in a broader range of circumstances than ever before.4 Historically, second-lien loans were used in large part to pay off existing debt or provide temporary incremental liquidity. Moreover, second-lien loans can provide greater flexibility for lenders and borrowers alike. Many private investors such as hedge funds, specialized finance companies and mezzanine funds are not regulated and are not constrained by internal credit risk ratings. These investors are veterans of the workout arena, are looking for true risk/return oriented structures and can review each potential deal on its own merits without many of the constraints that exist in large lending institutions.5 Further, given appropriate pricing, some senior lenders are attracted to extending financing for a second-lien loan, second to its own asset-based loan. Second liens are advantageous to borrowers as well—for example, borrowers can use the financing provided by the second-lien loan to gain time to reduce debt and improve performance before seeking access to traditional capital markets.6 Moreover, as more opportunities for second-lien financing become available, pricing of second-lien financing is becoming competitive, can be varied and also can be creatively crafted to compensate for risk and projected future value of the enterprise while remaining cheaper than traditional unsecured credit. Accordingly, creative lenders and borrowers have given birth to a new loan structure, and it appears as though it will remain on the lending landscape.
Second liens, frequently referred to as Tranche B or junior secured debt, usually work in tandem with an asset-based loan.7 Typically, the junior loan has the same rights and covenants as the senior loan except it stands second in line as far as repayment priority.8 The junior debt-holder contractually agrees with the senior debt that until the senior debt is paid in full, the junior debt will not receive some, or all, of the payments under the debt instrument. Accordingly, while not as strong as a first-lien secured position, second lien-holders do stand ahead of other subordinated debt and general unsecured creditors. Most commonly, secured second liens can be structured one of two ways. In one way, the first lien is secured by all the available assets while the second lien relies on incremental dollars against the same collateral pool—very similar in concept to a second mortgage on a home. In another way, the first and second liens are secured by different pools of collateral. For example, one loan is secured by receivables and inventory and another uses the fixed assets such as property, plant and equipment for collateral.9 The types of collateral are varied and can encompass any type of collateral traditionally used to secure an asset-based loan.10
In a typical silent second-lien transaction, a bank or other lender (or a lending group) takes a first lien on all or substantially all of a borrower's assets. The debt may or may not be guaranteed by affiliated companies or additionally secured by their assets. The borrower generally has other creditors such as trade or general unsecured creditors.11 A lender, consortium, hedge fund, bond group or other investors (acting for themselves or for public or private capital markets) can then extend credit to the same borrower, taking a second lien on all or substantially all of the assets upon which the first secured creditor has a lien.12
The second lien becomes "silent" when, pursuant to the terms of an intercreditor agreement or like document, the second lienholder agrees to give up many of the rights it has as a second lienholder upon an event of default or in the event of a bankruptcy case commenced by or against the borrower. Commonly, second lienholders become silent by agreeing to such terms as the ones listed below:
- It will not object to validity, priority or enforceability of the first lienholder's position;
- Senior lienholder will be entitled to all proceeds from the collateral until it is paid in full, even if the senior lien is invalidated;
- Agreement not to object to debtor-in-possession (DIP) financing in a bankruptcy proceeding if requested or approved by senior lien holder;
- To abide by the senior lienholder positions with respect to adequate protection, use of cash collateral, sale of assets and relief from stay;
- To waive or severely limit its ability to vote on any reorganization plan and will not vote in favor of any plan opposed to by the senior secured creditor, or that it assigns its right to vote to the senior secured creditor.13
More specifically, as to voting-right restrictions, senior lenders generally ask junior lien-investors to agree to five basic types of voting restrictions:
- "A blanket agreement to allow the senior-lien lenders to vote the second-lien claims as they see fit, either for or against a plan;
- An agreement not to vote against any plan supported by the senior-lien lenders (regardless of its contents);
- An agreement not to vote against any plan supported by the senior-lien lenders, unless the plan would have a material adverse impact on the junior-lien lenders (such as if the junior-lien creditors would fare better in a liquidation of the company than under the plan);
- An agreement not to vote in favor of a plan, unless the senior-lien creditors vote in favor of the plan or the plan meets certain conditions (such as providing for payment in full in cash of the senior-lien creditors); and
- An agreement not to vote for any plan that contains certain terms and conditions (such as a provision that provides that the senior-lien lenders get less than 100 percent cash recovery)."14
Silent second liens are attractive to junior lenders as well because such security affords the junior lienholders a greater recovery than unsecured lenders and also gives junior lienholders rights (subject to the limitations placed on some of these rights by the first lien lenders), which include, inter alia:
- the right to adequate protection under the Bankruptcy Code
- the potential for post-petition interest under the Code
- the right to consent or object to extensions of credit to a DIP that prime pre-petition liens
- the right to be heard on the use of collateral and the sale of collateral by the DIP.
- The right to be placed in a separate class in a reorganization plan. Historically, secured creditors have had much higher recovery rates than unsecured creditors.
While the silent second lien transaction is popular and widely used, only time will tell whether, when the loans default (and some inevitably will), bankruptcy courts will, or even have the authority to, enforce many of the commonly included provisions when presented in the context of a chapter 11 case. While there are many issues that could arise in a chapter 11 scenario, the following attempts to outline the most critical issues where enforceability is probably of greatest concern to lenders.
Interest that would accrue after the filing of a bankruptcy petition can be a very substantial part of a claim. The Code provides that interest can be paid currently during the bankruptcy proceeding to secured creditors.15 However, for a creditor to be allowed post-petition interest, the bankruptcy court must find that the value of the collateral exceeds the amount of the claim of such creditor—in other words, that the creditor is "oversecured." The inclusion of the first liens and second liens in the same class would require the collateral pool to cover both the first-lien claims and the second-lien claims (not just the first-lien claims). Thus, it would be more difficult to show that the first lien claim is oversecured. Having separate loan documents and separate agents enhances the argument that the first-lien claims and the second-lien claims can be classified separately. The payment of post-petition interest may also be limited by the rule of explicitness and the recent decision issued by the First Circuit, which are discussed in detail in the Bank of New England case, will be more fully discussed in Part II of this article.16
DIP Financings, Cash Collateral and Adequate Protection
First-lien lenders also want the second-lien lenders to agree not to object to DIP financing or use of cash collateral in any bankruptcy proceeding that is approved by the first-lien lenders. The DIP lender will commonly get a superpriority "priming" lien on collateral senior to other secured lenders, including the pre-petition first-lien loans and second-lien loans. In order to grant the priming lien or to use the cash collateral, the debtor must show that the other secured creditors are "adequately protected"—i.e., that it will not suffer loss of collateral value while a borrower is in bankruptcy. To protect its position and maintain control of the process, the first-lien lenders will often want to provide the DIP financing and control the use of cash collateral. The first-lien lenders will want to restrict the ability of the second-lien lenders to argue that they are not adequately protected or to otherwise disrupt the first-lien lenders' control of the process (such as by submitting a competing DIP). The market has begun to dictate that second-lien lenders retain their general rights to adequate protection (except that the intercreditor agreement will typically provide that the second-lien lender waive its right to raise adequate protection objections with respect to DIP financings and the use of cash collateral approved by the first lien). However, it is more common to see second-lien lenders object to provisions that limit their rights to object to DIP financing or the use of cash collateral. The area is unsettled, and the overall enforceability of the adequate protection waivers will be discussed more fully in Part II of this article.
First-lien lenders want the second-lien lenders not to object to the lifting of automatic stay in a bankruptcy proceeding if requested or approved by the first-lien lenders. The automatic stay may be lifted to permit foreclosure on a piece of collateral and sale of the collateral (which cannot be done without the consent of all of the lienholders on that collateral, including the second-lien lenders). Thus, the first-lien lenders will seek the advance waiver of the right to contest the lifting of the stay from the second-lien lenders. The second-lien lenders might object to providing such waiver due to the possibility that a collateral sale will not be done to protect its residual value.
Plan of Reorganization
First-lien lenders want the second-lien lenders to agree to support a reorganization plan in a bankruptcy proceeding supported by the first-lien lenders. In most transactions, the second-lien lenders will agree to do so. One possible way to assure that first lenders control the ability to confirm a reorganization plan is by obtaining in the intercreditor agreement restrictions on the rights of the second-lien lenders with respect to voting for reorganization plans. It is rare for the second-lien lenders to fully waive their rights to vote in connection with a plan because the right to vote on a plan and to object to its confirmation provides very meaningful protections for a secured creditor. The waiver of such rights may cause the second-lien lender to have fewer rights than an unsecured lender and trade creditors (both of whom rarely agree to limit their voting rights in a plan). The enforceability of voting waivers is in question and discussed elsewhere herein. The first-lien lenders may not want to take the liability risk of actually voting the claims of the second-lien lenders. Therefore, first-lien lenders often require a covenant of the second-lien lenders to support any plan proffered by the first-lien lenders. A detailed discussion of the enforceability of the commonly included plan restrictions will be addressed in Part II of this article.
Other Bankruptcy Issues
Second-lien lenders commonly waive the right to (1) oppose the sale of collateral in a §363 sale or as part of a reorganization plan, or (2) contest the value of the collateral to be sold. Although these are common provisions in second-lien inter-creditor arrangements, they have the anomalous effect of taking away rights the second-lien lenders would have if they were unsecured. However, most second-lien lenders conclude it's better to have the collateral and generally will agree to a waiver of such rights.
Silent-second-lien transactions are advantageous for lenders and borrowers alike. They provide more flexibility and access to capital than traditional secured lending. However, are the commonly included provisions in these transactions, many of which provide essential elements upon which first lien lenders rely, enforceable if the borrower ultimately files a chapter 11 petition? Will the lenders get what they bargained for? Should borrowers care about what happens later among the creditors as long as they receive the needed funding today?
1 Ms. Brighton is special counsel with Kennedy Covington Lobdell & Hickman in Charlotte, N.C., in the Financial Services Department - Financial Restructuring Group, where she practices primarily in the areas of bankruptcy, workouts and secured lending. She is a contributing editor for the ABI Journal, serving on its Editorial Board, and sits on the Advisory Board for the ABI Law Review. She is certified in Business Bankruptcy Law by the American Board of Certification and is a frequent author and lecturer on bankruptcy-related topics. Return to article
2 See "Second Lien Financings—A Review of Intercreditor Issues," Ropes & Gray Debt Financing Newsletter, March 2004; Seife, Howard, "Silent Second Liens," 121 Banking Law Journal 771 (October 2004). Return to article
14 "Why Second Lien Investors Are Thinking Twice about Bankruptcy Voting Restrictions," CapitalEyes, Bank of America Business Capital Newsletter (October 2004); citing Cummings, Neil, The Deal, Sept. 21, 2004. Return to article