Second-Lien Financing Part V Who Gets What

Journal Issue

Jul/Aug 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 6, p. 38, July/August 2006

Bankruptcy Code

363

Topic Tags

Asset Sales

Journal HTML Content

In our past four articles in this series,3 we have explored the relationship
between first- and second-lien lenders and how the structure of that relationship,
often embodied in the intercreditor agreement, has impacted the course of a
reorganization of the borrower. Further, we have discussed the tensions between
the contractual rights contained in the intercreditor agreement, the expectations
of the parties and the reality of the bankruptcy process. We now turn our attention
to that rarest of commodities, a court's written decision relevant to the interplay
between first and second liens. The decision comes to us in the chapter 11 cases
of WestPoint Stevens Inc. and its affiliates, filed in the Southern District
of New York on June 1, 2003.4 Judge Laura Taylor Swain of
the U.S. District Court for the Southern District of New York reversed a decision
of the bankruptcy court that had permitted the secured claims of the first-lien
lenders to be satisfied by the transfer to those first-lien lenders of minority
interests in the equity of the parent of the acquiring company. That minority
interest was part of the consideration paid in the context of the §363
sale of the debtors' assets. With the first-lien lenders thereby paid in full,
albeit not in cash, the bankruptcy court had ordered that the balance of the
purchase price, represented by additional equity in the parent of the acquiring
company, could be disbursed to the second-lien lenders.5

Background6
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
Document Analysis
 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:

<blockquote>
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....

</blockquote>
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
Statutory Analysis
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.
<blockquote> </blockquote>

<hr>
<h3>Footnotes</h3>

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.

Journal Authors

Jo Ann J. Brighton

Mark N. Berman

Journal Date

Saturday, July 1, 2006 - 12:00

Bankruptcy Rule

2006

362

none