Second-Lien Financings Part III The Good the Bad and the Ugly Atkins the Good News at 11

This is the third installment in a series of
articles that focus on the actual experiences realized when
second-lien financings hit the bankruptcy courts. In the second
installment printed in the March <i>Journal</i>, we explored the

<i>American Remanufacturers</i> case.¹ This third installment

explores the <i>Atkins Nutritionals Inc.</i>, <i>et al</i>, chapter 11

cases. As a reminder, this report is purely anecdotal.²
However, it is readily apparent that the comparisons with the first
installment could not be more striking. <i>Atkins</i> resulted in a
confirmed chapter 11 reorganization plan, a continuing business
operation, and both first- and second-lien lenders participating in
the reorganized company. By contrast, <i>American Remanufacturers</i>

cratered at the very start—unable to resolve differences between

the first- and second-lien lenders on the terms of the 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 gained a
thing by the battle over rights between the first- and second-lien
holders contained in the intercreditor agreement. </p><p><b>Background and
Workout</b> </p><p>The Atkins story has its roots in 1972, when Dr. Atkins
published his first book about low carbohydrate (low-carb) dieting. A
second book on the same topic was published in the '90s and became a
best-seller. Paralleling the publishing of second book, Dr. Atkins
established a corporation that introduced a low-carb food product in
1997. More products followed, and as the low-carb diet became a
significant force in American society, the company grew to meet a
growing demand. In 2003, the company, Atkins Nutritionals, was
acquired by Parthenon Capital Inc. and its affiliates along with
Goldman Sachs Capital Partners and its affiliates. While the
acquisition included a significant amount of equity put into the
company by its new owners, it also included a significant credit
facility in which UBS served as the agent for a syndicate of secured
lenders. The credit facility involved a single credit agreement,3 and
UBS served as the single collateral and administrative agent for two
levels of secured debt. The first level was granted a first lien on
substantially all assets of Atkins Nutritionals and its affiliates,
while the second level was granted a second lien on those same assets.

Each level was widely syndicated. </p><p>However, the low-carb diet revealed

itself as a fad, and the growth of demand for Atkins Nutritionals
cooled in 2004 as the company's performance was further hit by
competitive products from established food manufacturers. Later in 2004,

Atkins Nutritionals defaulted on its pre-petition credit agreement. A
workout ensued. </p><p>During the workout, several things became apparent.

First, the first-lien lenders could "control" the process by

outvoting the second-lien lenders on those matters governed by the
pre-petition credit agreement. As a result, declaring a default or
taking enforcement actions that might be the subject of an intercreditor

agreement and a resultant standstill period for the second-lien
lenders were all in the control of the first-lien lenders, who
dominated due to the size of the first-lien credit when compared to
the second-lien credit.⁴ </p><p>Second, there was a significant
amount of cross-ownership of the first- and second-lien positions, so
much so that it became difficult to find lenders who participated in
only one of the positions and who would be willing to serve on a
steering committee (a group often formed when a syndicated secured loan

goes into default in order to make the process of negotiation and
decision-making more streamlined). As a result, most lenders looked at

the credit facility from a total-return standpoint rather than
exclusively from the standpoint of the first- or second-lien position.

This probably reduced the amount of friction between the two
positions.</p><p>Third, many of the lenders who had acquired their positions

via trading had a perception that their rights were different than the

documentation revealed was true. Several first-lien lenders believed
they enjoyed the benefits of debt subordination rather than only lien
subordination. The "waterfall" provisions of the credit
agreement addressed only distributions from collateral and not
payments that the first- or second-lien lenders might obtain outside
of collateral liquidation. </p><p>Fourth, the first-lien lenders generally
favored a quick sale of the company where they could realize what they

believed to be the current value of the company. The first-lien
lenders believed that the liquidation of the company would result in
less than payment in full of their first-lien position. </p><p>Fifth, the
second-lien lenders generally wanted a chance to realize the value
that might be created over and above the first-lien position if the
company could be reorganized and proceed profitably into the future.
While the second-lien lenders feared that a sale of the company would
leave them with nothing, they also believed that with the benefit of
the new management team and other operational changes, there was a
realistic chance for a greater return down the road. Accordingly, the
second-lien lenders believed that their collateral had real value if the

business could continue as a going concern. </p><p>Sixth, none of the
parties, or their advisors, were sure of how reorganization securities

would be dealt with in a chapter 11 case (<i>i.e.</i>, whether the
equity to be issued in a chapter 11 reorganization would be considered
the proceeds of the first- and second-lien lenders' collateral).
</p><p>These forces resulted in the negotiation of a pre-bankruptcy lock-up
agreement being entered into by the first- and second-lien lenders.
The lock-up agreement contemplated a chapter 11 filing, a DIP credit
facility geared to providing the debtor with sufficient funds to
ensure operations during the chapter 11 process and a plan that would
either allow the company to be reorganized with both first- and
second-lien lenders sharing in the reorganized company, or a sale of
the business should a reasonable good prospect appear. </p><p><b>The Chapter

11 Case</b> </p><p> Atkins Nutritionals filed its chapter 11 case in the
Southern District of New York on July 31, 2005. At that time, there
was approximately $300 million in secured debt with $216 million held
by the first-lien lenders and $84 million held by the second-lien
lenders. Unsecured trade payables amounted to about $36 million. Of
course, the debtor had the benefit of the pre-negotiated plan
represented in the lock-up agreements between the first- and second-lien

lenders. What remained was what would happen to general unsecured
creditors who stood to get nothing based on the pre-negotiated deal.

</p><blockquote><blockquote>
<hr>
<big><i><center>
In any bankruptcy, dealing with limited assets expeditiously will always

be more beneficial than standing on supposed contractual rights and
litigating while the assets continue to decline in value.
</center></i></big>
<hr>
</blockquote></blockquote>

<p>A series of first-day motions produced the expected result, and the
DIP credit facility was approved by the bankruptcy court and put in
place. No sale materialized, and the deal represented by the lock-up
agreement was made the subject of the reorganization plan. As a result

of the creditors' committee raising issues arising out of the 2004
acquisition and threatening litigation against the family of Dr.
Atkins, a deal was reached that involved the Atkins family funding a
15 percent cash dividend for unsecured creditors in exchange for a
release of all claims. First-lien lenders received the right to
participate in a new $110 million post-petition credit facility
secured by a first lien on all assets. The remainder of the first-lien

debt, and all of the second-lien debt, was converted into equity in
the reorganized debtor. Equity provided to second-lien lenders and
management included special rights that acted like warrants if the value

that could be derived from the business on a sale exceeded $115
million. A management-incentive plan was put in place providing not
only for equity ownership, but also for bonuses upon the happening of
certain events. </p><p>All told, assuming there is value in the stock of the

reorganized company, the first-lien lenders received value equal to
100 percent of their claim plus the benefit of the pricing and
participation in the DIP facility. They also secured the collateral to

themselves alone should the post-chapter 11 operations falter and only

liquidation value be realized. The second-lien position assuming an
$18 million value on the reorganized company stock provided to them
recovered value of approximately 20-25 percent. </p><p>The future fate of
the reorganized company will bear out whether Atkins works out for the

first- and second-lien lenders. Can it sustain a profitable operation?

Will a sale of the business as a going concern be realized at greater
than the $115 million price? It would appear at first blush that the
second-lien lenders recovered more than they would have had the assets

been liquidated in a chapter 7 case or even sold as a going concern in

a §363 sale during the chapter 11 case. Ostensibly, any recovery
for second-lien lenders must have been at the expense of the
first-lien lenders.⁵ However, it is fair to say that the
chapter 11 process worked smoothly. Employee jobs were saved. The
first-lien lenders continue to earn interest on a reduced first-lien
credit facility, both first- and second-lien lenders have a piece of
the equity in the reorganized company, and unsecured creditors got an
immediate cash dividend. </p><p>The more difficult question to answer is
this: Why did <i>Atkins</i> work out this way (<i>i.e.</i>, with a
confirmed chapter 11 plan), when <i>American Remanufacturers</i>,
having converted to chapter 7, did not? Were the polar opposite results
a function of the Atkins credit facility utilizing a single credit
agreement, a single security agreement and a single agent? Or was the
negotiated-for result a function of Atkins having significant
cross-ownership in the pools of first- and second-lien lenders so that

the bank group as a whole was oriented to finding the best possible
return on their investment in both pools rather than pushing one to the
disadvantage of the other? In the end, one thing seems clear: In any
bankruptcy, dealing with limited assets expeditiously will always be
more beneficial than standing on supposed contractual rights and
litigating while the assets continue to decline in value. </p><p>Stay
tuned. Next month we will discuss two other recent bankruptcy cases that

involved second-lien financing and the resultant inter-creditor
issues—the <i>New World Pasta</i>, a.k.a. <i>Ronzoni</i>, and
the <i>Maxim Crane</i> bankruptcy cases. </p><h3> Footnotes</h3><p> 1
(Delaware-Case no. 05-200022) (filed 11/7/05) (Judge Walsh). </p><p>2 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. </p><p>3 It has become more common for second-lien lenders to
insist upon separate credit agreements with separate security
agreements and UCC financing statements to document their secured
loans with an inter-creditor agreement being negotiated between the
two. <i>See</i> Kerr and Rovito, "Second Lien Evolution Creates
Higher Recovery Prospects–At First Lien Lenders' Expense,"

<i>Ratings Direct</i>, Aug. 5, 2005. </p><p>4 The authors believe that
most current second-lien financings documented today involve separate
credit agreements for the first- and second-lien lenders. This
approach enhances the likelihood that a bankruptcy court will view the
two sets of lenders as holding separate loans rather than as
participants in a single loan. This issue has ramifications for
classification in chapter 11 plans as well as the right to accrue
post-petition interest and adequate protection. As can be seen from
the <i>Atkins Nutritionals</i> experience, it also has ramifications
for the ability of the second-lien lenders to impact the workout and
chapter 11 process. <i>See In re Ionosphere Clubs Inc.</i>, <i>et
al</i>, 134 B.R. 528 (S.D.N.Y. 1991). </p><p>5 <i>See</i> Kerr and Rovito,

"Second Lien Evolution Creates Higher Recovery Prospects–At

First-Lien Lenders' Expense," <i>Ratings Direct</i>, Aug. 5,
2005. </p>