Silent Second Lien Financings Popular Lending Structure May Give Rise to Enforcement Problems Part I What Is a Silent Second Lien Financing

Journal Issue

Feb 2005

Column Name

Feature

Bankruptcy Code

506

Topic Tags

Automatic Stay

Practice and Procedure

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Part I of this article will explain the
structure of second lien loan transactions ("silent second liens") and
highlight some of the key bankruptcy issues associated therewith. Part
II, to be published in the March issue of the ABI Journal, will
discuss in detail the enforceability of many of the common provisions of

silent second lien transactions and the cases that have addressed some
of the issues.

<h4>Typical Structure of Silent Second Lien Loans</h4>

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.<a href="#2" name="2a">2</a> 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.<a href="#3" name="3a">3</a> 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.<a href="#4" name="4a">4</a>

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.<a href="#5" name="5a">5</a>
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.<a href="#6" name="6a">6</a> 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.<a href="#7" name="7a">7</a> 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.<a href="#8" name="8a">8</a> 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.<a href="#9" name="9a">9</a> The
types of collateral are varied and can encompass any type of collateral
traditionally used to secure an asset-based loan.<a href="#10" name="10a">10</a>

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.<a href="#11" name="11a">11</a> 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.<a href="#12" name="12a">12</a>

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:

<ul>
<li>It will not object to validity, priority or enforceability of the
first lienholder's position;

</li><li>Senior lienholder will be entitled to all proceeds from the
collateral until it is paid in full, even if the senior lien is
invalidated;

</li><li>Agreement not to object to debtor-in-possession (DIP) financing in a

bankruptcy proceeding if requested or approved by senior lien holder;

</li><li>To abide by the senior lienholder positions with respect to adequate

protection, use of cash collateral, sale of assets and relief from stay;

</li><li>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.<a href="#13" name="13a">13</a>

</li></ul>

More specifically, as to voting-right restrictions, senior lenders
generally ask junior lien-investors to agree to five basic types of
voting restrictions:
<ul>
<li>"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;

</li><li>An agreement not to vote against any plan supported by the
senior-lien lenders (regardless of its contents);

</li><li>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);

</li><li>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

</li><li>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)."<a href="#14" name="14a">14</a>
</li></ul>

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:

<ul>

<li>the right to adequate protection under the Bankruptcy Code

</li><li>the potential for post-petition interest under the Code

</li><li>the right to consent or object to extensions of credit to a DIP that

prime pre-petition liens

</li><li>the right to be heard on the use of collateral and the sale of
collateral by the DIP.

</li><li>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.
</li></ul>

<h4>Bankruptcy Issues</h4>

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.

<h4>Post-petition Interest</h4>

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.<a href="#15" name="15a">15</a> 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.<a href="#16" name="16a">16</a>

<h4>DIP Financings, Cash Collateral and Adequate Protection</h4>

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.

<h4>Automatic Stay</h4>

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.

<h4>Plan of Reorganization</h4>

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.

<h4>Other Bankruptcy Issues</h4>

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.

<h4>Conclusion</h4>

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?

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> 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. <a href="#1a">Return
to article</a>

<a name="2">2</a> 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). <a href="#2a">Return to article</a>

<a name="3">3</a> See "Completing
the Capital Structure with a Second Lien Loan," CapitalEyes, Bank of
America Business Capital Newsletter (April 2003). <a href="#3a">Return to article</a>

<a name="4">4</a> "Why Today's Borrowers
and Investors are Leaning Toward Second Liens," CapitalEyes, Bank of
America Business Capital Newsletter (February 2004). <a href="#4a">Return to article</a>

<a name="5">5</a> Id. <a href="#5a">Return to article</a>

<a name="6">6</a> Id. <a href="#6a">Return to article</a>

<a name="7">7</a> CapitalEyes, supra

note 4. <a href="#7a">Return to article</a>

<a name="8">8</a> Id. <a href="#8a">Return to article</a>

<a name="9">9</a> CapitalEyes, supra

note 4. <a href="#9a">Return to article</a>

<a name="10">10</a> Id. <a href="#10a">Return to article</a>

<a name="11">11</a> See Seife,
supra note 2 at 772. <a href="#11a">Return to article</a>

<a name="12">12</a> Id. <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at 774. <a href="#13a">Return to article</a>

<a name="14">14</a> "Why Second Lien
Investors Are Thinking Twice about Bankruptcy Voting Restrictions,"