Second-Lien Financings Enforcement of Intercreditor Agreements in Bankruptcy1 Part I More Questions than Answers

Journal Issue

Feb 2006

Column Name

News at 11

Citation

ABI Journal, Vol. XXV, No. 1, p. 38, February 2006

Topic Tags

Practice and Procedure

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Unfortunately, it appears unlikely that we will
see for some time a seminal court decision that will provide clear
guidance on the likelihood that a bankruptcy court will enforce those
provisions in an intercreditor agreement that are intended to conform
the actions of the first and second lienholders during a bankruptcy
proceeding of the common borrower. 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
The Market 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? 3. Plans• 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
interest rate? • If so, and if the plan does not provide
otherwise, what are the terms of the crammed down first-lien debt?

4. Classification• 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? 7. Recharacterization• 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. <blockquote> <blockquote> 
</blockquote></blockquote><hr><h3>Footnotes</h3>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.

Journal Authors

Jo Ann J. Brighton

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

none