A Senior Secured Lender's Guide to the Risks Posed By Junior Secured Debt

Lien Subordination Versus Payment Subordination

This article focuses exclusively on “lien subordination” situations, ie, those where the rights of one lien holder (or group of lien holders) are senior to those of another lien holder (or group of lien holders) with respect to common collateral. Thus, references to “senior lender,” “junior lender,” or “subordination” refer to priorities with respect to the common collateral only. This article does not address the entirely different situation where a lender agrees that its rights to be paid from any source will be subordinated to the rights of another lender (situations referred to as “payment subordination”).

The Growing Junior Secured Debt Market

An overall tightening in the credit markets in 2001 and 2002, characterized by lower leverage multiples and increasing LIBOR spreads, set the stage for a rapidly growing market for a loan product to fill the gap left by tightened credit standards for asset-based loans. As interest rates remained at historic lows, investors, flush with liquidity and responding to the improved outlook for many corporate issuers, eagerly embraced high yield debt securities. As part of this trend, many investors were attracted to the idea of junior secured debt facilities. These products increase borrowers' ability to attract incremental debt capital that is senior to high yield unsecured instruments in right of payment from the collateral. Strong demand pushed the market for junior secured debt to historic highs in 2003, with $3.2 billion in new issues tracked by Standard & Poor's, compared with $470 million in 2002. This was dramatically higher than the earlier peak of $615 million in 1998.

The Role of the Intercreditor Agreement

When two or more secured lenders have claims against the same collateral, it is essential that they enter into a formal agreement governing their respective rights in the collateral. Thus, when junior secured debt is to be issued, an intercreditor agreement between the senior lender and the junior lender (with the borrower as an additional party) is used to dictate the nature and extent of the junior lender's rights and obligations. The terms of the intercreditor agreement will vary from deal to deal, along a continuum from “shallow” subordination (where the junior lender's rights are only subordinated to a very limited extent) to “deep” subordination (where the junior lender's rights are subordinated in every way). Whether a given intercreditor agreement results in shallow or deep subordination will depend on the relative bargaining positions of the parties, and their respective credit assessments and risk appetites.

Negotiating the Intercreditor Agreement

With certain exceptions, courts generally interpret subordination provisions of intercreditor agreements very narrowly. Often referred to as the “doctrine of explicitness,” this legal rule provides that unless the senior lender's rights over the junior lenders are explicitly spelled out in the agreement, they are not recognized. As a consequence, an intercreditor agreement governing subordination should address with specificity all elements of the senior-junior-borrower relationship.

Intercreditor agreements, like most of the documents utilized in sophisticated financing transactions, can appear to the non-lawyer as a mind-numbing maze of technicalities and “lawyer-speak.” But since there is a full spectrum of levels of subordination ' from shallowest to deepest ' it is important that the business principals understand the elements that go into determining the level of subordination, and make informed choices in negotiating each of these elements.

Delineation of Senior and Junior Claims Covered By the Subordination Agreement

The intercreditor agreement should clearly spell out in detail all of the claims of the senior lender that are to be considered superior to the claims of the junior lender. In addition to the senior lender's claims for principal, interest, and prepayment or other premiums on loans made under the credit agreement, the intercreditor agreement should also provide seniority to claims for:

• Fees and costs provided for in the senior lender's loan documents;
• Reimbursement obligations, interest, and fees under letters of credit issued by the senior lender;
• Obligations under derivative transactions between the senior lender and the borrower;
• Obligations of the borrower to the senior lender arising from cash management and other account services;
• All amounts advanced under the senior loan documents, whether subsequently repaid and re-borrowed;
• Additionally, the definition of the senior loan documents should cover any amendments, modifications, supplements, extensions, replacements, and refinancings of the loan documents;
• Amounts repaid by the senior lender to the borrower on account of preference, fraudulent conveyance, or other avoidance actions against the senior lender.

The intercreditor agreement should also provide seniority for the senior lender's claims for interest, fees, costs, and other obligations accruing after the commencement of a bankruptcy or other insolvency case by the debtor, whether or not allowed in the case. Without express provision for the seniority of these items (often referred to in general terms as “post-petition” interest), they may not have priority over the junior debt in a bankruptcy case.

The intercreditor agreement should also explicitly delineate the junior lender's claims that are covered by the subordination provisions. Here again, the senior lender will want to have as broad a scope as possible, and should include the same items listed above to ensure that all of the junior lender's potential claims are treated as subordinated secured obligations.

As is the case in many of the provisions in an intercreditor agreement, the senior and junior lenders will have opposite goals in negotiating these provisions ' the senior lender will want a broad definition of senior and junior claims while conversely, the junior lender will want these items delineated as narrowly as possible. For instance, a junior lender will often seek to limit the amount of the senior secured obligations to a fixed principal amount, or a percentage of the borrowing base availability under the senior secured loan agreement. Additionally, the junior lender will often want senior obligations to reduce as the senior facilities reduce through prepayments. A junior lender will resist the potential to increase the amount of senior secured obligations through amendments, refinancings, or increases in fees and interest rates. Junior lenders also frequently request that there be limits on the amount of senior secured obligations arising from other exposure such as cash management services and derivative transactions.

Extent of Lien Subordination

The intercreditor agreement will specify the extent of the subordination of the junior lender's liens. Here again, the senior lender will want the subordination of all liens held by the junior lender, regardless of how the liens arise, whether under the junior lender's loan documents, by statute, by operation of law, or otherwise. Specifically, the senior lender may require that the intercreditor agreement provide that:

• The senior liens will continue to have priority over the junior liens even if the senior liens become subordinate or even invalid with respect to creditors other than the junior lender, including through lack of perfection;
• Any additional liens that the junior lender obtains on assets that are not part of the common collateral will be assigned to the senior lender, with only a junior lien retained by the junior lender;
• Any judgment liens that the junior creditor obtains on the common collateral as an unsecured creditor (ie, not on account of its junior debt) will be treated as junior liens subject to the intercreditor agreement.

Standstill Agreements

The senior lender will insist that the junior lender agree to “standstill” and refrain from taking enforcement action against common collateral, at least for a specified period of time following certain defaults. The list of additional constraints on the junior lender's enforcement actions can be short or very extensive, including agreement by the junior lender that it will:

• Not take any action that would result in giving the junior liens equal standing with, or greater priority than, the senior liens;
• Not oppose, object to, or interfere with any disposition of collateral by the senior lender;
• Not sue the senior lender with respect to the common collateral or the provisions of the senior loan documents;
• Not commence an insolvency proceeding against the borrower;
• Not require that the senior lender “marshal” (ie, gather and liquidate) other collateral of the borrower that is not part of the common collateral with the junior lender;
• Not challenge the validity of the senior liens (this is usually a mutual agreement, where both the senior and junior lenders agree not to challenge each other's liens).

Following the expiration of any standstill period, the junior lender generally may engage in full foreclosure activity against any collateral that is not already subject to proceedings begun by the senior lender. Junior lenders will often request limits on the number of standstill periods that may occur in a given time period (often 365 days) and over the life of the transaction.

Exclusive Enforcement Rights

As a corollary to the standstill provisions, the senior lender will want the intercreditor agreement to provide that the senior lender has the exclusive right to take enforcement actions against the common collateral. In some cases, a senior lender may also insist that it have the exclusive right to demand payment, accelerate debt, exercise set-offs, or pursue other secured creditor remedies.

Waiver of Right of Redemption

Under state law, any lien holder is entitled to “redeem” collateral that is subject to a foreclosure proceeding by paying off the amounts owed to senior lien holders. While this should, in theory, result in payment in full of the senior lender's claims (if all such claims have been properly delineated so that they are covered by the senior lien), the uncertainty whether a junior lien holder will exercise its “right of redemption” may chill a senior lien holder's efforts to obtain the highest sale price for the common collateral. Accordingly, an intercreditor agreement should address rights of redemption. The senior lender will want a complete waiver by the junior lender of any right of redemption. The junior lender might request a limited right that is clearly spelled out with specific time frames and procedures, as a way of addressing a senior lender's concerns that the right could chill a foreclosure sale process.

Application of Proceeds of Collateral

The intercreditor agreement specifies that the proceeds of the common collateral will be applied first to pay the claims of the senior lender (as specifically defined in the intercreditor agreement) in full prior to any payment of the claims of the junior lender. As discussed above, this priority of payment will be subject to any agreed limits on the amount of the senior secured obligations.

Turnover

The intercreditor agreement should state that if the junior lender obtains any proceeds of the common collateral before the senior obligations are paid in full, the junior creditor must turn over those proceeds to the senior lender, subject to any agreed limits on the amount of senior secured obligations.

Lien Releases upon Disposition of Collateral

It is important that the intercreditor agreement provide that the junior lien against the common collateral will be automatically released ' without the need for any further action by the junior lender ' in the event that any of the common collateral is sold or otherwise disposed of in accordance with the senior loan documents. This ensures that the senior lender will be able to more effectively control the disposition process, and will not need the consent of the junior lender for dispositions. Without such a provision, the junior lender would have holdup bargaining leverage because a buyer of the collateral will want clean title. In agreeing to automatic lien releases, a junior lender will negotiate for some restrictions on dispositions, including a bar on dispositions of assets for less than a certain percentage of fair value.

Next month's installment of this series will continue with elements of the senior-junior-borrower relationship that should be addressed with specificity in an intercreditor agreement.

Part One of a Two-Part Series

In theory, a borrower's issuance of junior secured debt is a boon for its senior secured lender. The borrower obtains additional capital, and the claims of the junior lender against shared collateral, since “subordinated,” don't diminish the senior lender's prospects for repayment. In practice, however, a senior secured lender should view proposed junior secured financing skeptically because the existence of such debt can become highly problematic for the senior lender. The key to protecting the senior lender lies in properly negotiating and documenting the intercreditor agreement with the junior lender to eliminate, or at least minimize, the myriad ways in which the junior lender's rights may, in practice, limit ' or even trump ' those of the senior lender.

This article describes the key elements of an intercreditor agreement that should be carefully negotiated by the business principals structuring the deal. In addition, the article outlines a senior secured lender's options for protecting its interests in transactions involving junior secured debt. Many of these elements might appear to be arcane or rarely relevant. However, when financial distress strikes the borrower, these devilish “details” in the intercreditor agreement can make all the difference in the senior lender's ultimate recoveries.

Lien Subordination Versus Payment Subordination

This article focuses exclusively on “lien subordination” situations, ie, those where the rights of one lien holder (or group of lien holders) are senior to those of another lien holder (or group of lien holders) with respect to common collateral. Thus, references to “senior lender,” “junior lender,” or “subordination” refer to priorities with respect to the common collateral only. This article does not address the entirely different situation where a lender agrees that its rights to be paid from any source will be subordinated to the rights of another lender (situations referred to as “payment subordination”).

The Growing Junior Secured Debt Market

An overall tightening in the credit markets in 2001 and 2002, characterized by lower leverage multiples and increasing LIBOR spreads, set the stage for a rapidly growing market for a loan product to fill the gap left by tightened credit standards for asset-based loans. As interest rates remained at historic lows, investors, flush with liquidity and responding to the improved outlook for many corporate issuers, eagerly embraced high yield debt securities. As part of this trend, many investors were attracted to the idea of junior secured debt facilities. These products increase borrowers' ability to attract incremental debt capital that is senior to high yield unsecured instruments in right of payment from the collateral. Strong demand pushed the market for junior secured debt to historic highs in 2003, with $3.2 billion in new issues tracked by Standard & Poor's, compared with $470 million in 2002. This was dramatically higher than the earlier peak of $615 million in 1998.

The Role of the Intercreditor Agreement

When two or more secured lenders have claims against the same collateral, it is essential that they enter into a formal agreement governing their respective rights in the collateral. Thus, when junior secured debt is to be issued, an intercreditor agreement between the senior lender and the junior lender (with the borrower as an additional party) is used to dictate the nature and extent of the junior lender's rights and obligations. The terms of the intercreditor agreement will vary from deal to deal, along a continuum from “shallow” subordination (where the junior lender's rights are only subordinated to a very limited extent) to “deep” subordination (where the junior lender's rights are subordinated in every way). Whether a given intercreditor agreement results in shallow or deep subordination will depend on the relative bargaining positions of the parties, and their respective credit assessments and risk appetites.

Negotiating the Intercreditor Agreement

With certain exceptions, courts generally interpret subordination provisions of intercreditor agreements very narrowly. Often referred to as the “doctrine of explicitness,” this legal rule provides that unless the senior lender's rights over the junior lenders are explicitly spelled out in the agreement, they are not recognized. As a consequence, an intercreditor agreement governing subordination should address with specificity all elements of the senior-junior-borrower relationship.

Intercreditor agreements, like most of the documents utilized in sophisticated financing transactions, can appear to the non-lawyer as a mind-numbing maze of technicalities and “lawyer-speak.” But since there is a full spectrum of levels of subordination ' from shallowest to deepest ' it is important that the business principals understand the elements that go into determining the level of subordination, and make informed choices in negotiating each of these elements.

Delineation of Senior and Junior Claims Covered By the Subordination Agreement

The intercreditor agreement should clearly spell out in detail all of the claims of the senior lender that are to be considered superior to the claims of the junior lender. In addition to the senior lender's claims for principal, interest, and prepayment or other premiums on loans made under the credit agreement, the intercreditor agreement should also provide seniority to claims for:

• Fees and costs provided for in the senior lender's loan documents;
• Reimbursement obligations, interest, and fees under letters of credit issued by the senior lender;
• Obligations under derivative transactions between the senior lender and the borrower;
• Obligations of the borrower to the senior lender arising from cash management and other account services;
• All amounts advanced under the senior loan documents, whether subsequently repaid and re-borrowed;
• Additionally, the definition of the senior loan documents should cover any amendments, modifications, supplements, extensions, replacements, and refinancings of the loan documents;
• Amounts repaid by the senior lender to the borrower on account of preference, fraudulent conveyance, or other avoidance actions against the senior lender.

The intercreditor agreement should also provide seniority for the senior lender's claims for interest, fees, costs, and other obligations accruing after the commencement of a bankruptcy or other insolvency case by the debtor, whether or not allowed in the case. Without express provision for the seniority of these items (often referred to in general terms as “post-petition” interest), they may not have priority over the junior debt in a bankruptcy case.

The intercreditor agreement should also explicitly delineate the junior lender's claims that are covered by the subordination provisions. Here again, the senior lender will want to have as broad a scope as possible, and should include the same items listed above to ensure that all of the junior lender's potential claims are treated as subordinated secured obligations.

As is the case in many of the provisions in an intercreditor agreement, the senior and junior lenders will have opposite goals in negotiating these provisions ' the senior lender will want a broad definition of senior and junior claims while conversely, the junior lender will want these items delineated as narrowly as possible. For instance, a junior lender will often seek to limit the amount of the senior secured obligations to a fixed principal amount, or a percentage of the borrowing base availability under the senior secured loan agreement. Additionally, the junior lender will often want senior obligations to reduce as the senior facilities reduce through prepayments. A junior lender will resist the potential to increase the amount of senior secured obligations through amendments, refinancings, or increases in fees and interest rates. Junior lenders also frequently request that there be limits on the amount of senior secured obligations arising from other exposure such as cash management services and derivative transactions.

Extent of Lien Subordination

The intercreditor agreement will specify the extent of the subordination of the junior lender's liens. Here again, the senior lender will want the subordination of all liens held by the junior lender, regardless of how the liens arise, whether under the junior lender's loan documents, by statute, by operation of law, or otherwise. Specifically, the senior lender may require that the intercreditor agreement provide that:

• The senior liens will continue to have priority over the junior liens even if the senior liens become subordinate or even invalid with respect to creditors other than the junior lender, including through lack of perfection;
• Any additional liens that the junior lender obtains on assets that are not part of the common collateral will be assigned to the senior lender, with only a junior lien retained by the junior lender;
• Any judgment liens that the junior creditor obtains on the common collateral as an unsecured creditor (ie, not on account of its junior debt) will be treated as junior liens subject to the intercreditor agreement.

Standstill Agreements

The senior lender will insist that the junior lender agree to “standstill” and refrain from taking enforcement action against common collateral, at least for a specified period of time following certain defaults. The list of additional constraints on the junior lender's enforcement actions can be short or very extensive, including agreement by the junior lender that it will:

• Not take any action that would result in giving the junior liens equal standing with, or greater priority than, the senior liens;
• Not oppose, object to, or interfere with any disposition of collateral by the senior lender;
• Not sue the senior lender with respect to the common collateral or the provisions of the senior loan documents;
• Not commence an insolvency proceeding against the borrower;
• Not require that the senior lender “marshal” (ie, gather and liquidate) other collateral of the borrower that is not part of the common collateral with the junior lender;
• Not challenge the validity of the senior liens (this is usually a mutual agreement, where both the senior and junior lenders agree not to challenge each other's liens).

Following the expiration of any standstill period, the junior lender generally may engage in full foreclosure activity against any collateral that is not already subject to proceedings begun by the senior lender. Junior lenders will often request limits on the number of standstill periods that may occur in a given time period (often 365 days) and over the life of the transaction.

Exclusive Enforcement Rights

As a corollary to the standstill provisions, the senior lender will want the intercreditor agreement to provide that the senior lender has the exclusive right to take enforcement actions against the common collateral. In some cases, a senior lender may also insist that it have the exclusive right to demand payment, accelerate debt, exercise set-offs, or pursue other secured creditor remedies.

Waiver of Right of Redemption

Under state law, any lien holder is entitled to “redeem” collateral that is subject to a foreclosure proceeding by paying off the amounts owed to senior lien holders. While this should, in theory, result in payment in full of the senior lender's claims (if all such claims have been properly delineated so that they are covered by the senior lien), the uncertainty whether a junior lien holder will exercise its “right of redemption” may chill a senior lien holder's efforts to obtain the highest sale price for the common collateral. Accordingly, an intercreditor agreement should address rights of redemption. The senior lender will want a complete waiver by the junior lender of any right of redemption. The junior lender might request a limited right that is clearly spelled out with specific time frames and procedures, as a way of addressing a senior lender's concerns that the right could chill a foreclosure sale process.

Application of Proceeds of Collateral

The intercreditor agreement specifies that the proceeds of the common collateral will be applied first to pay the claims of the senior lender (as specifically defined in the intercreditor agreement) in full prior to any payment of the claims of the junior lender. As discussed above, this priority of payment will be subject to any agreed limits on the amount of the senior secured obligations.

Turnover

The intercreditor agreement should state that if the junior lender obtains any proceeds of the common collateral before the senior obligations are paid in full, the junior creditor must turn over those proceeds to the senior lender, subject to any agreed limits on the amount of senior secured obligations.

Lien Releases upon Disposition of Collateral

It is important that the intercreditor agreement provide that the junior lien against the common collateral will be automatically released ' without the need for any further action by the junior lender ' in the event that any of the common collateral is sold or otherwise disposed of in accordance with the senior loan documents. This ensures that the senior lender will be able to more effectively control the disposition process, and will not need the consent of the junior lender for dispositions. Without such a provision, the junior lender would have holdup bargaining leverage because a buyer of the collateral will want clean title. In agreeing to automatic lien releases, a junior lender will negotiate for some restrictions on dispositions, including a bar on dispositions of assets for less than a certain percentage of fair value.

Next month's installment of this series will continue with elements of the senior-junior-borrower relationship that should be addressed with specificity in an intercreditor agreement.