Second-Lien Financings Good Bad and Ugly

Journal Issue

Jun 2006

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Citation

ABI Journal, Vol. XXV, No. 5, p. 1, June 2006

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This is the fourth installment in a series of
articles that focus on the parties' actual experiences in cases where
second-lien financings have hit the bankruptcy courts.3 In
the third installment printed in the May issue of the Journal,
we explored the Atkins Nutritionals, Inc., et al,
chapter 11 cases.4 This fourth installment explores the

Maxim Crane and New World Pasta chapter 11
cases.5 As a reminder, these reports are purely
anecdotal.6 In the prior installments, we explored how
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. In contrast, American
Remanufactures cratered at the very start—unable to resolve
the differences between first- and second-lien lenders on the terms of

the debtor-in-possession (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 benefited by the battle over rights
between the first- and second-lien holders contained in the
intercreditor agreement. In this installment, we will see first how

Maxim Crane highlights the potential benefits of a negotiated
resolution via the bankruptcy process in contrast to the strict
enforcement of the contractual rights found in intercreditor
agreements. Then we will turn our attention to New World Pasta,
which illustrates how the crucial early proceedings in the bankruptcy
case may affect the ability of the parties to enforce the provisions
of the intercreditor agreement at a later time in the case.
Maxim Crane Works When first reviewing the Maxim
Crane case, the initial question that comes to mind, and which has

been posed to these authors, is this: What did the first-lien lenders
do wrong in documenting the pre-petition credit facility? After all,
the result of the Maxim Crane chapter 11 case was that the
senior lenders gave up some of their contractual rights to seniority
under the intercreditor agreement and their right to insist upon
application of the absolute priority rule and allowed value to flow
downhill not only to second-lien lenders (who, given the economics of
the case, would have otherwise received nothing), but also to
unsecured creditors. The answer surprises many bankers and
nontraditional lenders, but should not surprise bankruptcy
professionals who have experience with the practical realities of the
bankruptcy process. Very simply, the answer is "nothing."
There was nothing "wrong" with the intercreditor
document—nor was there any legal weakness in the position of the
first-lien lenders. Conversations with counsel involved in the case
confirm that the agreement by the first-lien lenders to allow some
value to trickle down to the second-lien lenders and unsecured
creditors was instead driven by their desire to (1) see the case move
along quickly, (2) participate in the DIP loan, (3) receive payment
more quickly (and with more certainty as to amount) and (4) eliminate
risk.

<hr>
<big><center>
Second lienholders should carefully review all DIP, cash collateral and
adequate-protection motions made early in the case, as well as the
proposed orders submitted by debtors and first-lien lenders acting in
concert.
</center></big>
<hr>
</blockquote></blockquote>

To set the stage for this
discussion: The debtors, headquartered in Pittsburgh, constituted
North America's largest crane-rental operation. They had an assumed
enterprise value of approximately $475 million. Arrayed against that
value was debt that totaled about $700 million. The debt was divided
into four levels. The senior, or Tranche A lenders, were secured by a
first lien on all assets and were owed approximately $473 million.
Tranche B held a junior lien on all assets and was owed about $50
million. Tranche C, also secured by a lien on assets, was owed $9.1
million. A fourth level of secured notes was owed about $190 million.
Clearly, given the reality of the value of the debtor's assets and the

costs of the reorganization process, no creditors besides those in
Tranche A "should" have received anything. A
pre-negotiated plan had been agreed upon prior to the debtors'
bankruptcy filing. It provided that the first-lien lenders would
receive a 90 percent recovery with some of that return represented by
participation in a new secured credit facility and the balance in most

of the equity of the reorganized debtor. The second-lien lenders would

receive 9 percent of the common stock of the reorganized debtor plus
warrants. Their recovery was represented in the disclosure statement
as worth 43 percent of what they were owed. The third level of secured
debt was to receive nothing, but that level was controlled by the
first-lien lenders through an intercreditor agreement. The fourth
level of secured debt was to receive warrants. All of the secured
creditors were to receive releases. As the bankruptcy process evolved,

the first-lien lenders were able to provide a DIP credit facility that

allowed them to earn additional fees resulting in a greater than 90
percent overall recovery for the first-lien lenders. A cash recovery
and litigation pool was structured for unsecured creditors that,
depending on the litigation recoveries, would return between 24 and 50

percent of what the unsecured creditors were owed. The plan was
confirmed six months after the chapter 11 filing, and the reorganized
debtor emerged from chapter 11 shortly thereafter. Back to the
initial question posed in this discussion: If the Tranche A lenders
were truly senior to the other lenders and their position was slightly
underwater, and the intercreditor agreement was enforceable, why would

the Tranche A lenders agree to any recovery at all for the junior
lenders and unsecured creditors? The answer lies in the first-lien
lenders' recognition of how the bankruptcy process works: Time is
short, resources are limited, assets are worth what they are worth,
and, as the American Remanufactures case demonstrates, sometimes

it does not make sense to stand on your rights and fight for the sake
of fighting. The disclosure statement reveals the first-lien lenders'
dilemma. While the enterprise value of $475 million meant that the
senior lenders were just a bit underwater, a chapter 7 liquidation was

projected to result in a substantial loss of value where the
first-lien lenders would recover only 45 percent of what they were
owed. It was obvious that the first-lien lenders wanted—and
needed—to find a way to realize a going-concern value and avoid
liquidation. To accomplish this goal, the first-lien lenders made the
decision to distribute some of that enterprise value to other
constituencies but secured to themselves a sure return of substantial
proportion. This made the case a relatively brief one, maintained the
going-concern value of the business, eliminated any risk that a
greater value might have been found by the court in a contested
valuation dispute at confirmation, and left them in a position to
enhance that recovery if the reorganized debtors' equity should
increase in value. "[A]bsolute priority is often merely a
theoretical starting point from which the intercreditor negotiations
depart."7 More often than not, as the Atkins case

highlights, parties fare much better when they work together with a
recognition of a common goal of maximizing recovery as a whole.

There was simply no reason to believe that the intercreditor
agreement in Maxim Crane was anything other than iron-clad and
fully enforceable. However, the Maxim Crane first-lien lenders
were faced with the same quandary that most senior lenders face when
they do not enjoy a recognized and substantial equity cushion in
collateral. Absent a negotiated agreement, junior secured and
unsecured creditors could use the chapter 11 forum to argue about the
validity, priority and amount of the first-lien lenders' secured
claims, contest the terms of the DIP credit facility, contest the
valuation of the reorganized debtors, and otherwise cause the chapter
11 case to be expensive, time consuming and bitter. After all, if the
junior creditors are not allowed to share in the recovery, there is
little for them to lose and much to be gained if they are ultimately
successful (even marginally). Certainly, the first-lien lenders might be

able to fight back by trying to stand on their rights to absolute
priority and seek to enforce the terms of the intercreditor agreement.

However, it is not clear that a bankruptcy court will take
jurisdiction of disputes between secured creditors over the
enforceability of an intercreditor agreement and that would leave the
senior lenders with nothing more than a state court breach of contract
claim to pursue. Furthermore, unsecured creditors are not party to the

intercreditor agreement and are therefore free to raise any of these
issues without fear of reprisal from the senior lenders. An
enlightened first-lien lender will often be eager to limit the length
of the chapter 11 proceeding, cut down on the resultant legal and
other professional fees associated with a long and contentious chapter

11 case, and produce a result that exceeds what would happen in a
liquidation. The first-lien lenders also might secure to themselves
the fees that flow from the DIP credit facility, avoid a costly
valuation fight, obtain post-petition releases and secure to
themselves the vast majority of the upside represented by control of
the equity of the reorganized business. New World Pasta,
a.k.a. Ronzoni New World Pasta8 presents

a different story. It's another Pennsylvania case begun about the same

time as Maxim Crane, but this one was in the Middle District of

Pennsylvania. No pre-negotiated plan was pursued. Instead, the debtor
came into the chapter 11 proceeding with a proposed DIP credit
facility to be provided by the first-lien lenders. However, the proposed

DIP order contained a clause to which the second-lien lenders
objected. It provided: <blockquote> The rights and remedies of the
pre-petition junior lenders, with respect to the subordinate
obligations, if any, shall only be exercised in a manner consistent
with and subject to the pre-petition credit agreement and pre-petition

participation agreements. </blockquote>Clearly, the first-lien
lenders wanted the bankruptcy court to order the second-lien lenders
to abide by the terms of the intercreditor agreements. The second-lien

lenders were astute, picked up on the goals of the first-lien lenders
and sought to avoid that result. Objections were filed by the junior
lienholders to the motions requesting approval of the DIP financing,
the use of cash collateral and the adequate protection finding (the
"Objections"). In the Objections, the junior lienholders
acknowledged that the debtor needed the post-petition financing on a
super-priority basis, but requested that the court strike certain
provisions of the DIP order as "offending language" since, in
the objecting creditors' opinion, that language "potentially
deprives the pre-petition junior lenders of fundamental bankruptcy
rights and protections that cannot be traded away in pre-petition
agreements to the extent that [such agreements] purport to do
so."9 The "offending language" had been
crafted by the first-lien lenders and placed into the DIP order in
order to enforce provisions of the inter-creditor
agreement—namely, a waiver from the pre-petition junior lenders
of the rights to adequate protection and to vote on the chapter 11
plan.10 The Objections acknowledged the cases previously
cited by these authors concerning the enforceability of certain
provisions of the intercreditor agreement and argued that any order
approving the DIP financing and authorizing cash collateral should not

be used to obtain declaratory or injunctive relief on these unsettled
issues of the enforceability of waiver provisions by junior lienholders
in bankruptcy cases.11 The Objections further argued that
the enforceability of the "offending language" can only be
properly decided as part of an adversary proceeding.12 The

New World court issued a final order approving the DIP financing,

the use of cash collateral and the adequate-protection finding (the
"order").13 It specifically approved the
subordination of payment of the junior creditors to the senior
creditors.14 However, the final order dropped the
"offending language" and replaced it with: <blockquote>
38. Pre-petition Participation Agreement. Notwithstanding anything in

this order to the contrary, the pre-petition participation
agreements are in full force and effect, and nothing herein shall
alter, modify, amend or effect the terms and conditions of the
pre-petition participation agreements, and nothing herein is or
shall be deemed a waiver of any rights or remedies of the
pre-petition agent or pre-petition senior lenders thereunder. Nothing

in this order shall be deemed to alter, amend, prejudice or waive the
rights of the pre-petition senior lenders or the pre-petition junior

lenders with respect to the subordinate obligations under the
pre-petition credit agreement and the pre-petition participation
agreements, provided, however, that in the event a court of
appropriate jurisdiction finds that the pre-petition junior lenders'

and/or JLL's agreements and waivers contained in the pre-petition
credit agreement and/or the pre-petition participation agreements are
enforceable, the pre-petition agent preserves its rights to enforce
such agreements and waivers retroactively to the petition date,
including revoking any protections previously granted to the
pre-petition junior lenders and/or JLL (including, without
limitation, those protections contained in that certain stipulation
and Agreed Interim Order entered by this court on May 10, 2004, and any
final order entered with respect thereto), which protections upon
such revocation shall be deemed void ab initio and of no force and
effect. </blockquote>There is no reported decision that explains
the basis for the court's order. Counsel involved in the dispute have
shared that the objections filed by the second-lien lenders were
resolved consensually. Specifically, the "offending
language," and any appearance of approval of the underlying waivers

or injunctive or declaratory relief, was removed and replaced with
reservations of rights by all. In other words, the fight was reserved
for a later day. While the New World Pasta case does not
answer the question of the enforceability of the waivers and other
concessions typically found in the intercreditor agreements that
accompany silent second liens, it is instructive in many ways. First,
the order confirms that there are no clear answers to the question at
hand. Second, the objection filed by the second-lien lenders suggests
that approval of DIP financing, cash collateral and adequate
protection in bankruptcy cases involving pre-petition facilities with
second liens may be construed as a blessing of the underlying loan
documents and the waivers they contain. The ultimate change in the
language seems to imply that such a conclusion is possible and may in
fact act as an estoppel against raising the issues later. Finally,

New World Pasta reveals why the issue of the enforceability of
various provisions in intercreditor agreements of bankruptcy cases may
never be resolved in a reported decision. These issues are often
consensually resolved in the early days of the case while the debtor
hangs precariously awaiting its DIP financing or resolved in the
context of a larger settlement allocating value amongst the various
levels of debt. As discussed earlier, once a bankruptcy case is filed,

time is short: DIP financing and permission to use cash collateral
need to be in place essentially before the case is filed. In a majority
of cases, the borrower/debtor is so highly leveraged that there is no
ability to wage a successful priming fight, and DIP credit facilities
provided by the pre-petition senior lenders are the only real game in
town. Issues need to be resolved quickly, and no one benefits, not the

least of which the junior lenders, if precious time is lost and the
borrower's money is spent on litigating valuation or intercreditor
issues. Settlement is often in everyone's best interest. It may be
worthwhile for junior lenders to litigate waivers or assignments of
their right to vote their claims at plan confirmation time and to
engage in a valuation fight at that time, but in the meantime, all
issues of the enforceability of intercreditor provisions concerning
DIP financing, the use of cash collateral, the right to adequate
protection, the release of liens on sales of collateral and the right
to seek relief from the automatic stay have faded into the past. In the
meantime, waivers or assignments of the right to vote the claims of
the second-lien lenders are becoming increasingly less common in
intercreditor agreements used in second-lien financings. It is simply
likely that by the time most plans are presented for confirmation,
most of these issues will have also been resolved consensually by the
parties. Conclusion In the end, Maxim Crane was a
simple balance-sheet restructuring in which the parties, as in
Atkins, agreed to work together. The Tranche A lenders'
recovery of more than 90 percent is not bad for any bankruptcy case
and avoided the disaster of a liquidation. The second lienholders and
unsecured creditors happily received a recovery they would not
otherwise be entitled to based on the assumed enterprise value. Even
more impressive, Maxim Crane was in and out of bankruptcy in
approximately six months. New World Pasta also demonstrates
the advantages of settlement. However, first-lien lenders would be
wise to try to "shore up" their positions in DIP and cash
collateral pleadings (although query whether such beneficial language
would be enforceable if it is buried in the hundreds of pages of
first-day pleadings and the bankruptcy judge has not been made aware
of the implications of the specific language blessing the
intercreditor agreement). Second lienholders should carefully review
all DIP, cash collateral and adequate-protection motions made early in

the case, as well as the proposed orders submitted by debtors and
first-lien lenders acting in concert. At the very least, junior
lienholders should file a limited objection reserving all rights to
raise enforceability issues under the provisions of the intercreditor
agreement. Stay tuned. We pledge to scour the horizon for other
bankruptcy cases that involved second-lien financings and report to
you on the resultant intercreditor issues.<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 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 to 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, Brighton, Jo Ann J., "Second Lien
Financing: More Questions than Answers," ABI Journal, Vol.

XXV, No. 2 (February 2006); Berman, Mark, Brighton, Jo Ann J.,
"Second Lien Financing Part II: Anecdotes: The Good, the Bad, and
the Very Ugly," ABI Journal, Vol. XXV, No. 2 (March 2006);

Berman, Mark, Brighton, Jo Ann J., "Second Lien Financing Part
III: Anecdotes: The Good, the Bad, and the Very Ugly, ABI
Journal, Vol. XXV, No. 4 (May 2006). 4 (Delaware-Case No.
05-200022) (filed 11/7/05) (Judge Walsh). See, also,
Berman, Mark, Brighton, Jo Ann J., "Second Lien Financing
Anecdotes: The Good, the Bad, and the Very Ugly," ABI
Journal, Vol. XXV, No. 4 (May 2006). 5 Parent case was ACR
Management LLC et al., No. 04-27848 (W.D. Pa. filed June 14,
2004). In re New World Pasta, No. 04-02817 (M.D. Pa. filed May
10, 2004). 6 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. 7 Kerr and Rovito, "Second-Lien Evolution
Creates Higher Recovery Prospects—At First Lien Lenders'
Expense," Ratings Direct, Aug. 22, 2005. 8 In re New
World Pasta, No. 04-02817 (M.D. Pa. filed May 10, 2004). 9

See 2004 WL 1484987 at 2. 10 Id. at 3. 11 Id.

12 Id. 13 In re New World Pasta, No. 04-02817 (M.D.
Pa. filed May 10, 2004) (issuing final order authorizing (a) secured
post-petition financing on a super-priority basis pursuant to 11
U.S.C. §364, (b) use of cash collateral pursuant to 11 U.S.C.
§363 and (c) grant of adequate protection pursuant to 11 U.S.C.
§§363 and 364, entered July 9, 2004.). 14 Id. at 9,
25-26.

Journal Authors

Jo Ann J. Brighton

Mark N. Berman

Journal Date

Thursday, June 1, 2006 - 12:00

Bankruptcy Rule

2006

none