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

In order to preserve the status quo with respect to the junior lending arrangements, the senior lenders will want the intercreditor agreement to restrict the junior lender's ability to change the junior lender's loan documents, while at the same time allowing the senior lender to change its loan documents and retain the full effect of the subordination agreements. Such provisions include agreements that:

• Neither the borrower, the senior lender, nor the junior lender will amend or modify the senior or junior loan documents in any manner that violates or is inconsistent with the intercreditor agreement.
• Any waiver, modification, or amendment by the senior lender to the senior loan documents will apply automatically to any comparable provision of the junior loan documents, without further action by the junior lenders. The junior lender may insist on carve-outs from this provision to preclude the senior lender from agreeing to a modification to its loan agreement that has a material adverse effect on the junior lender without a similar material adverse effect on the senior lender. In addition, the junior lender may insist that the modifications by the senior lender not have the effect of releasing common collateral (unless pursuant to a sale or other disposition permitted in the intercreditor agreement).

Agreements to Override a Junior Lien Holder's Statutory Rights

The Uniform Commercial Code (the “UCC”) and real property law provide certain rules regarding the relationship between a junior and senior lien holder when they are not otherwise specifically spelled out by the parties. These rules are more protective of a junior lien holder than a senior lien holder would prefer, and give the junior lien holder the following rights:

• The right to demand that the senior lender marshal assets ' ie, look first to other collateral that is not part of the common collateral ' before liquidating the common collateral. This can be problematic for the senior lender because the other collateral may be less liquid and more difficult to liquidate than the common collateral.
• The right to notice before a senior lender liquidates common collateral. This may delay the senior lender in enforcing its rights.
• The possible right, if the junior lien holder is the party that forecloses, to keep all proceeds from the sale. Courts are divided on this issue, with some courts holding that if the senior lender is given “reasonable” notice of the junior lender's foreclosure, the senior lender is not entitled to any of the proceeds of the junior lender's foreclosure sale. Other courts have disagreed with this approach, but a prudent senior lender will nonetheless want the intercreditor agreement to bar a junior lender from foreclosing, and if it nonetheless does so, to agree that it will turn over all proceeds to the senior lender until the amounts secured by the senior lien are paid in full.
• The right to object to what is known as “strict foreclosure” (where the lien holder accepts the collateral itself in full or partial satisfaction of its lien) by the senior lien holder. Under the UCC, a lien holder seeking the remedy of strict foreclosure is required to give notice to both the borrower and all other lien holders. Those other lien holders have 20 days to object, which gives junior lien holders the right to derail the senior lien holder's efforts, creating significant bargaining leverage for the junior lender, particularly in cases where the collateral in question is cash or some other easily dispersed asset.
• The right to sue a senior lender by alleging that in foreclosing, the senior lender did not proceed in good faith, in a “commercially reasonable” manner, and with “reasonable” notification to other lien holders, or did not use “reasonable care” in holding or preserving any common collateral in its possession. These standards can result in highly subjective interpretations, and can result in expensive litigation.

Fortunately for senior lenders, these rules can generally be modified by intercreditor agreements that limit the junior lien holder's statutory rights, or otherwise vary the statutory rules. However, notwithstanding any provisions of an intercreditor agreement, the senior lien holder must comply with the somewhat nebulous requirements of good faith and commercial reasonableness. A carefully drafted intercreditor agreement is important in this respect, because it can clearly spell out the obligations and duties of the parties, to reduce the chances that a junior lender will have grounds to sue the senior lender.

DIP Financing in a Subsequent Bankruptcy Case

In addition to clearly delineating that the senior lender's claims for interest, fees, costs, and other accruals during a bankruptcy or other insolvency case will retain their seniority, the intercreditor agreement should specifically address other key issues that might arise if the borrower subsequently becomes a debtor under the Bankruptcy Code. In Chapter 11, a debtor can obtain post-petition financing of its operations during the case (known as debtor-in-possession (“DIP”) financing) by granting a lien to the DIP lender that is senior to (or “primes”) pre-petition liens. However, if the existing lien holders don't consent to such treatment, priming liens can only be granted if the debtor can prove that the security interests of existing lien holders are “adequately protected.” Generally, this means that the debtor must prove that the value of the collateral is greater than the total of all the liens ' pre-existing and proposed. When a debtor enters bankruptcy with all of its assets encumbered by liens that are greater than the value of those assets, it is unable to grant priming liens without the consent of those to be primed, and is likely to have few financing alternatives. Without adequate financing, a debtor's only choice may be to convert the case to a Chapter 7 liquidation.

Senior lenders may decide that they wish to provide the DIP financing in order to protect the viability of the business and their pre-petition loans, as well as to have a substantial say in the conduct of the Chapter 11 case through the DIP financing documents. Since the debtor is in Chapter 11 due to financial distress, it is likely that the value of the common collateral has diminished so that it is less than the amount of both the senior and junior liens. In such a situation, absent an agreement from the junior lender, the senior lender will be unable to provide secured DIP financing that primes the existing liens. This situation gives the junior lender significant bargaining leverage and can be very problematic for the senior lender. Accordingly, when negotiating the intercreditor agreement, the senior lender should seek to obtain the advance consent of the junior lender that its liens may be primed by any subsequent DIP financing provided by the senior lender, and that the relative rights of the senior and junior lenders will continue to be governed by the intercreditor agreement.

Not surprisingly, this will be a point of intense negotiation between the senior and junior lender when crafting the intercreditor agreement. The junior lender will resist giving the senior lender a blank check to add more senior debt ahead of it. In addition, if the senior loan is being provided by more than one lender, a further debate will arise: whether the advance consent should apply to secured DIP financing provided by a group consisting of all of the senior lenders, or merely by a subset of that group. This becomes a critical point in large lender groups because there may be members of the senior lender group that are not prepared to advance more money, or are prohibited by their own internal constraints from providing financing to a company in bankruptcy.

Use of Cash Collateral

Section 363 of the Bankruptcy Code authorizes a debtor to use, sell, or lease its property in the ordinary course of business without the consent of creditors or the supervision by the Bankruptcy Court, with one significant exception: The debtor may only use cash collateral with the consent of creditor(s) holding a valid lien on such collateral. Without such consent, the debtor must prove that the cash is “adequately protected” from diminution in value. As a practical matter, it is very difficult to prove that a secured lender's interest in cash is adequately protected if the debtor plans to spend the cash, so the debtor almost always must obtain the consent of the secured creditor(s) to use cash collateral. This can give the secured creditor significant bargaining leverage with the debtor.

A senior lender should seek to include a provision in the intercreditor agreement whereby the junior lender agrees in advance that if the senior lender consents to the debtor's use of cash collateral in a bankruptcy case, the junior lender will both consent and not seek to obtain adequate protection of its interest in the cash. Absent such an agreement, the junior lender will be able to block the senior lender's efforts to provide this form of financing for the debtor.

Separate Liens

The Bankruptcy Code provides certain protections and benefits to secured creditors that are unavailable to unsecured creditors. Importantly, however, a claim is considered “secured” under the Bankruptcy Code only to the extent of the value of the collateral. Thus, although a lender may have made a $100 million secured loan to a debtor, if the value of the collateral is only $70 million, the lender's “secured” claim under the Bankruptcy Code is deemed to be only $70 million, and the creditor is deemed to have an unsecured claim for $30 million.

Following the commencement of a bankruptcy case, an unsecured creditor is generally not entitled to collect interest, fees, and other costs that accrue during the bankruptcy case. By contrast, however, a secured creditor is entitled to accrue and eventually collect post-petition interest, fees, and costs, but only to the extent that the value of the creditor's interest in the collateral exceeds the total amounts claimed, ie, the creditor is found to be “oversecured.”

The senior lender should require that the senior and junior lenders have separate loan documents (including separate pledge agreements and separately documented liens) in order to minimize the chances that their rights will be lumped together with those of the junior lender. The intercreditor agreement should be the only common agreement. Otherwise, there is a significant risk that the senior lender would be unable to collect post-petition interest, fees, and costs unless the value of the common collateral is greater than the amount of both the senior and junior claims. For example, if the senior lender's loan is $200 million and the junior lender's loan is $150 million, but the common collateral is only worth $250 million, the senior lender would be entitled to post-petition interest, fees, and costs if its $200 million claim is compared to a first lien on collateral worth $250 million. But if there is a single set of loan documents for both senior and junior loans, the debtor or other parties in interest may succeed in denying post-petition interest, fees, and costs, to the senior lender by claiming that the value of the collateral ($250 million) is less than the amount of the common lien ($350 million).

Adequate Protection

A secured creditor is also entitled to be “adequately protected” from a decline in the value of any of its collateral that arises after the commencement of the bankruptcy case, so long as the secured creditor is barred by the automatic stay from taking possession of that collateral. After a request for adequate protection by a secured creditor, and a finding by the Bankruptcy Court that the collateral is, in fact, declining in value, the debtor must compensate the secured creditor for any such diminution in value. This compensation can take a variety of forms, including providing replacement liens, additional collateral, and even periodic cash payments.

A debtor's ability to provide “adequate protection” to its secured creditors to compensate them for declines in value in the collateral during a bankruptcy case is generally very limited. Accordingly, the senior lender should try to include in the intercreditor agreement provisions that the junior lender will not seek adequate protection until the senior lender has received adequate protection that it is satisfied with, and then only in the form of interests junior to those of the senior lender.

Stay Relief

At the commencement of a bankruptcy case, an “automatic stay” is imposed by section 362 of the Bankruptcy Code. This precludes creditors from taking or continuing actions against the debtor ' or its property ' to collect debts. Absent specific approval from the Bankruptcy Court, secured creditors may not seize collateral, effect offsets, or otherwise exercise many remedies available to them outside of bankruptcy. The automatic stay is very broad in scope and violations of the stay may result in court sanctions. If the senior lender decides to petition the Bankruptcy Court for relief from the automatic stay (or other stay in effect) to exercise remedies with respect to the common collateral, the junior lender should agree in advance to consent to the motion.

Asset Sales

Section 363 of the Bankruptcy Code also allows a debtor to sell, use, or lease its property outside the ordinary course of business, with the approval of the Bankruptcy Court. The debtor must prove that the transaction is in the best interests of the debtor and its creditors generally. The Bankruptcy Court can also approve sales of property free and clear of liens ' regardless of objections by the lien holder ' so long as the liens are transferred to the sale proceeds. Creditors and other parties in interest are entitled to object to such proposed transactions, and to challenge assertions that they satisfy the statutory requirements. In such a situation, the Bankruptcy Court must hear all relevant evidence and make a determination on the objection. Such contested “363 sales” can result in extensive litigation and delays in consummation of the transaction. The intercreditor agreement should provide that the junior lender will not oppose a “363 sale” that is supported by the senior lender, and be deemed to have consented to such sale, in order to minimize the ability of the junior lender to be disruptive of a sale process favored by the senior lender.

Separate Classes of Debt

Where the bankruptcy case is under Chapter 11 of the Bankruptcy Code, the case culminates in the filing and approval of a Chapter 11 plan for the debtor. The plan can provide for either the reorganization or the orderly liquidation of the debtor. The Bankruptcy Code imposes a number of detailed rules governing the form of a Chapter 11 plan, as well as the procedures for its acceptance by creditors and approval (or “confirmation”) by the Bankruptcy Court. Among those is a requirement that a plan sort all pre-petition claims into “classes,” based on their legal rights and remedies. Separate classes must be created for claims that are legally dissimilar, but legally similar claims can be placed in one class. The plan is voted on, and must be approved by creditors in at least one class of claims that is impaired under the plan, by a vote of at least one-half of the creditors voting in the class, who hold at least two-thirds of the amount of the claims of creditors who vote. Thus, so long as certain other provisions of the Bankruptcy Code are satisfied, a plan can be confirmed by the Bankruptcy Court and become effective, over the dissent of other classes of creditors, in this process known as “cram down.”

Since voting on a Chapter 11 plan is done by a class vote, if the claims of the senior and junior lenders are put in one class, the junior lenders (depending on the amount of their claims) may be able to control the class vote, with enough votes either to confirm a plan over the dissent of the seniors, or to block approval of a plan favored by the senior lenders. By having separate loan documents, the senior lender will likely be able to demonstrate that its legal rights are sufficiently different than those of the junior lender to entitle the senior lender to its own class. Ideally, the intercreditor agreement should also contain an agreement by the junior lender that its claims are dissimilar, and must be separately classified.

Chapter 11 Plan

In addition, the senior creditor should obtain an agreement from the junior lender that the senior lender is entitled to vote the junior lender's claim to accept or reject a Chapter 11 plan. Courts are currently divided on whether such an agreement is enforceable in bankruptcy. However, like any uncertain right, it is better to have than not have. In addition, to maximize the chances that the senior lender will be entitled to vote the junior lender's claim, the senior lender should request that the junior lender give the senior a security interest in its bankruptcy claim as well, since there are provisions in the Bankruptcy Rules which indicate that a party who holds another's claim as security can vote that claim in Chapter 11. Similar, less drastic, voting provisions include an agreement by the junior lender not to support a plan that the senior lender opposes, and not to oppose a plan that the senior lender supports.

Other Junior Lender Conduct in a Bankruptcy Case

The intercreditor agreement may also contain other provisions to protect the senior lender in the event of the borrower's subsequent bankruptcy. For example, the senior lender may require that the junior lender not take any action in the bankruptcy case that affects the common collateral, such as filing motions or pleadings (other than a proof of claim), raising objections, or taking positions at hearings. This would include a prohibition on the junior lender seeking relief from the automatic stay to proceed against the common collateral, or seeking adequate protection in regard to the common collateral, without the consent of the senior lender.

Conclusion

Junior secured debt has become a viable and important financing alternative for many borrowers, and may become a trend that a senior lender cannot ignore. However, if a senior lender embarks on a transaction involving junior secured debt, it should pay careful attention to the myriad of details in the intercreditor arrangements to ensure that it receives the intended benefit of its bargain.

Part Two of a Two-Part Series

The author continues her analysis of the elements of the senior-junior-borrower relationship that should be addressed with specificity in an intercreditor agreement.

Agreements with Respect to Modifications of Loan Documents

In order to preserve the status quo with respect to the junior lending arrangements, the senior lenders will want the intercreditor agreement to restrict the junior lender's ability to change the junior lender's loan documents, while at the same time allowing the senior lender to change its loan documents and retain the full effect of the subordination agreements. Such provisions include agreements that:

• Neither the borrower, the senior lender, nor the junior lender will amend or modify the senior or junior loan documents in any manner that violates or is inconsistent with the intercreditor agreement.
• Any waiver, modification, or amendment by the senior lender to the senior loan documents will apply automatically to any comparable provision of the junior loan documents, without further action by the junior lenders. The junior lender may insist on carve-outs from this provision to preclude the senior lender from agreeing to a modification to its loan agreement that has a material adverse effect on the junior lender without a similar material adverse effect on the senior lender. In addition, the junior lender may insist that the modifications by the senior lender not have the effect of releasing common collateral (unless pursuant to a sale or other disposition permitted in the intercreditor agreement).

Agreements to Override a Junior Lien Holder's Statutory Rights

The Uniform Commercial Code (the “UCC”) and real property law provide certain rules regarding the relationship between a junior and senior lien holder when they are not otherwise specifically spelled out by the parties. These rules are more protective of a junior lien holder than a senior lien holder would prefer, and give the junior lien holder the following rights:

• The right to demand that the senior lender marshal assets ' ie, look first to other collateral that is not part of the common collateral ' before liquidating the common collateral. This can be problematic for the senior lender because the other collateral may be less liquid and more difficult to liquidate than the common collateral.
• The right to notice before a senior lender liquidates common collateral. This may delay the senior lender in enforcing its rights.
• The possible right, if the junior lien holder is the party that forecloses, to keep all proceeds from the sale. Courts are divided on this issue, with some courts holding that if the senior lender is given “reasonable” notice of the junior lender's foreclosure, the senior lender is not entitled to any of the proceeds of the junior lender's foreclosure sale. Other courts have disagreed with this approach, but a prudent senior lender will nonetheless want the intercreditor agreement to bar a junior lender from foreclosing, and if it nonetheless does so, to agree that it will turn over all proceeds to the senior lender until the amounts secured by the senior lien are paid in full.
• The right to object to what is known as “strict foreclosure” (where the lien holder accepts the collateral itself in full or partial satisfaction of its lien) by the senior lien holder. Under the UCC, a lien holder seeking the remedy of strict foreclosure is required to give notice to both the borrower and all other lien holders. Those other lien holders have 20 days to object, which gives junior lien holders the right to derail the senior lien holder's efforts, creating significant bargaining leverage for the junior lender, particularly in cases where the collateral in question is cash or some other easily dispersed asset.
• The right to sue a senior lender by alleging that in foreclosing, the senior lender did not proceed in good faith, in a “commercially reasonable” manner, and with “reasonable” notification to other lien holders, or did not use “reasonable care” in holding or preserving any common collateral in its possession. These standards can result in highly subjective interpretations, and can result in expensive litigation.

Fortunately for senior lenders, these rules can generally be modified by intercreditor agreements that limit the junior lien holder's statutory rights, or otherwise vary the statutory rules. However, notwithstanding any provisions of an intercreditor agreement, the senior lien holder must comply with the somewhat nebulous requirements of good faith and commercial reasonableness. A carefully drafted intercreditor agreement is important in this respect, because it can clearly spell out the obligations and duties of the parties, to reduce the chances that a junior lender will have grounds to sue the senior lender.

DIP Financing in a Subsequent Bankruptcy Case

In addition to clearly delineating that the senior lender's claims for interest, fees, costs, and other accruals during a bankruptcy or other insolvency case will retain their seniority, the intercreditor agreement should specifically address other key issues that might arise if the borrower subsequently becomes a debtor under the Bankruptcy Code. In Chapter 11, a debtor can obtain post-petition financing of its operations during the case (known as debtor-in-possession (“DIP”) financing) by granting a lien to the DIP lender that is senior to (or “primes”) pre-petition liens. However, if the existing lien holders don't consent to such treatment, priming liens can only be granted if the debtor can prove that the security interests of existing lien holders are “adequately protected.” Generally, this means that the debtor must prove that the value of the collateral is greater than the total of all the liens ' pre-existing and proposed. When a debtor enters bankruptcy with all of its assets encumbered by liens that are greater than the value of those assets, it is unable to grant priming liens without the consent of those to be primed, and is likely to have few financing alternatives. Without adequate financing, a debtor's only choice may be to convert the case to a Chapter 7 liquidation.

Senior lenders may decide that they wish to provide the DIP financing in order to protect the viability of the business and their pre-petition loans, as well as to have a substantial say in the conduct of the Chapter 11 case through the DIP financing documents. Since the debtor is in Chapter 11 due to financial distress, it is likely that the value of the common collateral has diminished so that it is less than the amount of both the senior and junior liens. In such a situation, absent an agreement from the junior lender, the senior lender will be unable to provide secured DIP financing that primes the existing liens. This situation gives the junior lender significant bargaining leverage and can be very problematic for the senior lender. Accordingly, when negotiating the intercreditor agreement, the senior lender should seek to obtain the advance consent of the junior lender that its liens may be primed by any subsequent DIP financing provided by the senior lender, and that the relative rights of the senior and junior lenders will continue to be governed by the intercreditor agreement.

Not surprisingly, this will be a point of intense negotiation between the senior and junior lender when crafting the intercreditor agreement. The junior lender will resist giving the senior lender a blank check to add more senior debt ahead of it. In addition, if the senior loan is being provided by more than one lender, a further debate will arise: whether the advance consent should apply to secured DIP financing provided by a group consisting of all of the senior lenders, or merely by a subset of that group. This becomes a critical point in large lender groups because there may be members of the senior lender group that are not prepared to advance more money, or are prohibited by their own internal constraints from providing financing to a company in bankruptcy.

Use of Cash Collateral

Section 363 of the Bankruptcy Code authorizes a debtor to use, sell, or lease its property in the ordinary course of business without the consent of creditors or the supervision by the Bankruptcy Court, with one significant exception: The debtor may only use cash collateral with the consent of creditor(s) holding a valid lien on such collateral. Without such consent, the debtor must prove that the cash is “adequately protected” from diminution in value. As a practical matter, it is very difficult to prove that a secured lender's interest in cash is adequately protected if the debtor plans to spend the cash, so the debtor almost always must obtain the consent of the secured creditor(s) to use cash collateral. This can give the secured creditor significant bargaining leverage with the debtor.

A senior lender should seek to include a provision in the intercreditor agreement whereby the junior lender agrees in advance that if the senior lender consents to the debtor's use of cash collateral in a bankruptcy case, the junior lender will both consent and not seek to obtain adequate protection of its interest in the cash. Absent such an agreement, the junior lender will be able to block the senior lender's efforts to provide this form of financing for the debtor.

Separate Liens

The Bankruptcy Code provides certain protections and benefits to secured creditors that are unavailable to unsecured creditors. Importantly, however, a claim is considered “secured” under the Bankruptcy Code only to the extent of the value of the collateral. Thus, although a lender may have made a $100 million secured loan to a debtor, if the value of the collateral is only $70 million, the lender's “secured” claim under the Bankruptcy Code is deemed to be only $70 million, and the creditor is deemed to have an unsecured claim for $30 million.

Following the commencement of a bankruptcy case, an unsecured creditor is generally not entitled to collect interest, fees, and other costs that accrue during the bankruptcy case. By contrast, however, a secured creditor is entitled to accrue and eventually collect post-petition interest, fees, and costs, but only to the extent that the value of the creditor's interest in the collateral exceeds the total amounts claimed, ie, the creditor is found to be “oversecured.”

The senior lender should require that the senior and junior lenders have separate loan documents (including separate pledge agreements and separately documented liens) in order to minimize the chances that their rights will be lumped together with those of the junior lender. The intercreditor agreement should be the only common agreement. Otherwise, there is a significant risk that the senior lender would be unable to collect post-petition interest, fees, and costs unless the value of the common collateral is greater than the amount of both the senior and junior claims. For example, if the senior lender's loan is $200 million and the junior lender's loan is $150 million, but the common collateral is only worth $250 million, the senior lender would be entitled to post-petition interest, fees, and costs if its $200 million claim is compared to a first lien on collateral worth $250 million. But if there is a single set of loan documents for both senior and junior loans, the debtor or other parties in interest may succeed in denying post-petition interest, fees, and costs, to the senior lender by claiming that the value of the collateral ($250 million) is less than the amount of the common lien ($350 million).

Adequate Protection

A secured creditor is also entitled to be “adequately protected” from a decline in the value of any of its collateral that arises after the commencement of the bankruptcy case, so long as the secured creditor is barred by the automatic stay from taking possession of that collateral. After a request for adequate protection by a secured creditor, and a finding by the Bankruptcy Court that the collateral is, in fact, declining in value, the debtor must compensate the secured creditor for any such diminution in value. This compensation can take a variety of forms, including providing replacement liens, additional collateral, and even periodic cash payments.

A debtor's ability to provide “adequate protection” to its secured creditors to compensate them for declines in value in the collateral during a bankruptcy case is generally very limited. Accordingly, the senior lender should try to include in the intercreditor agreement provisions that the junior lender will not seek adequate protection until the senior lender has received adequate protection that it is satisfied with, and then only in the form of interests junior to those of the senior lender.

Stay Relief

At the commencement of a bankruptcy case, an “automatic stay” is imposed by section 362 of the Bankruptcy Code. This precludes creditors from taking or continuing actions against the debtor ' or its property ' to collect debts. Absent specific approval from the Bankruptcy Court, secured creditors may not seize collateral, effect offsets, or otherwise exercise many remedies available to them outside of bankruptcy. The automatic stay is very broad in scope and violations of the stay may result in court sanctions. If the senior lender decides to petition the Bankruptcy Court for relief from the automatic stay (or other stay in effect) to exercise remedies with respect to the common collateral, the junior lender should agree in advance to consent to the motion.

Asset Sales

Section 363 of the Bankruptcy Code also allows a debtor to sell, use, or lease its property outside the ordinary course of business, with the approval of the Bankruptcy Court. The debtor must prove that the transaction is in the best interests of the debtor and its creditors generally. The Bankruptcy Court can also approve sales of property free and clear of liens ' regardless of objections by the lien holder ' so long as the liens are transferred to the sale proceeds. Creditors and other parties in interest are entitled to object to such proposed transactions, and to challenge assertions that they satisfy the statutory requirements. In such a situation, the Bankruptcy Court must hear all relevant evidence and make a determination on the objection. Such contested “363 sales” can result in extensive litigation and delays in consummation of the transaction. The intercreditor agreement should provide that the junior lender will not oppose a “363 sale” that is supported by the senior lender, and be deemed to have consented to such sale, in order to minimize the ability of the junior lender to be disruptive of a sale process favored by the senior lender.

Separate Classes of Debt

Where the bankruptcy case is under Chapter 11 of the Bankruptcy Code, the case culminates in the filing and approval of a Chapter 11 plan for the debtor. The plan can provide for either the reorganization or the orderly liquidation of the debtor. The Bankruptcy Code imposes a number of detailed rules governing the form of a Chapter 11 plan, as well as the procedures for its acceptance by creditors and approval (or “confirmation”) by the Bankruptcy Court. Among those is a requirement that a plan sort all pre-petition claims into “classes,” based on their legal rights and remedies. Separate classes must be created for claims that are legally dissimilar, but legally similar claims can be placed in one class. The plan is voted on, and must be approved by creditors in at least one class of claims that is impaired under the plan, by a vote of at least one-half of the creditors voting in the class, who hold at least two-thirds of the amount of the claims of creditors who vote. Thus, so long as certain other provisions of the Bankruptcy Code are satisfied, a plan can be confirmed by the Bankruptcy Court and become effective, over the dissent of other classes of creditors, in this process known as “cram down.”

Since voting on a Chapter 11 plan is done by a class vote, if the claims of the senior and junior lenders are put in one class, the junior lenders (depending on the amount of their claims) may be able to control the class vote, with enough votes either to confirm a plan over the dissent of the seniors, or to block approval of a plan favored by the senior lenders. By having separate loan documents, the senior lender will likely be able to demonstrate that its legal rights are sufficiently different than those of the junior lender to entitle the senior lender to its own class. Ideally, the intercreditor agreement should also contain an agreement by the junior lender that its claims are dissimilar, and must be separately classified.

Chapter 11 Plan

In addition, the senior creditor should obtain an agreement from the junior lender that the senior lender is entitled to vote the junior lender's claim to accept or reject a Chapter 11 plan. Courts are currently divided on whether such an agreement is enforceable in bankruptcy. However, like any uncertain right, it is better to have than not have. In addition, to maximize the chances that the senior lender will be entitled to vote the junior lender's claim, the senior lender should request that the junior lender give the senior a security interest in its bankruptcy claim as well, since there are provisions in the Bankruptcy Rules which indicate that a party who holds another's claim as security can vote that claim in Chapter 11. Similar, less drastic, voting provisions include an agreement by the junior lender not to support a plan that the senior lender opposes, and not to oppose a plan that the senior lender supports.

Other Junior Lender Conduct in a Bankruptcy Case

The intercreditor agreement may also contain other provisions to protect the senior lender in the event of the borrower's subsequent bankruptcy. For example, the senior lender may require that the junior lender not take any action in the bankruptcy case that affects the common collateral, such as filing motions or pleadings (other than a proof of claim), raising objections, or taking positions at hearings. This would include a prohibition on the junior lender seeking relief from the automatic stay to proceed against the common collateral, or seeking adequate protection in regard to the common collateral, without the consent of the senior lender.

Conclusion

Junior secured debt has become a viable and important financing alternative for many borrowers, and may become a trend that a senior lender cannot ignore. However, if a senior lender embarks on a transaction involving junior secured debt, it should pay careful attention to the myriad of details in the intercreditor arrangements to ensure that it receives the intended benefit of its bargain.