First and Second Liens

Background

The Debtors had entered Chapter 11 two years before, but had been unable to come to a consensus with their creditors on a Chapter 11 reorganization plan. The Debtors faced financial ruin ' lacking sufficient cash to retire their debtor-in-possession financing and the secured claims held by the first lien holders.

Facing this crisis, Westpoint held a sale of substantially all of its assets pursuant to a court-ordered auction. The Sale Order, approving the asset sale, was entered. The first lien holders moved for an expedited appeal of the Sale Order and entered into a stipulation that stayed distribution of any securities to the second lien holders. Those securities were placed in escrow. The remaining aspects of the sale, including the distribution of securities to the first lien holders, proceeded as contemplated under the Sale Order.

On appeal, the District Court found that the Sale Order impaired the contractual right of the first lien holders to have their claims fully satisfied in cash ' finding that a non-cash distribution to the first lien holders could only be accomplished through the Chapter 11 plan confirmation process. In reversing certain provisions of the Sale Order (but approving the distribution of cash and securities to satisfy the first lien holders' claims), the District Court rejected arguments that a distribution of securities to first lien holders was authorized by: 1) the first lien holders' Credit Agreement; or 2) Sections 363(b) and 105(a) of the Bankruptcy Code.

Impairment of Contractual Rights

The District Court first looked to the first lien holders' Credit Agreement to determine if it contained the requisite authority for the bankruptcy court's findings that the Debtors' obligations could be satisfied through a non-cash distribution to first lien holders other than by cash. The District Court found that the bankruptcy court had wholly misconstrued ' 3.15(c) of the Credit Agreement in finding that distribution of non-cash consideration was permitted. Reviewing the contract as a whole, the District Court found the bankruptcy court's holding 'inconsistent with the plain language of ' 3.15 of the Credit Agreement' which clearly mandated cash only claim satisfaction. Specifically, the District Court held that Sections 3.15 (a) and (b) of the Credit Agreement required the Debtors to satisfy their contractual obligations to the first lien holders' only through cash consideration. Further, the District Court found that ' 3.15(c) of the Credit Agreement simply changed the order in which cash payments were to be applied after a borrower defaulted, to ensure that expenses incurred in collecting the defaulted obligation were covered first.

Sections 363(b) and 105(a) of the Bankruptcy Code

The District Court then turned to an analysis of Sections 363(b) and 105(a) of the Bankruptcy Code to determine if those sections contained the requisite authority for a non-cash distribution to first lien holders. Section 363(b) of the Bankruptcy Code allows a court to approve the sale of assets of the estate outside the ordinary course of business, provided there is a good business reason to do so. The District Court did not question the bankruptcy court's finding that, because of the Debtor's precarious financial position, a good business reason existed for approving a ' 363(b) sale. However, the District Court found that 'the provision of claim satisfaction through the in-kind distribution is ' inconsistent with the Objecting First Lien Holders' contractual rights and is outside the scope of the bankruptcy court's power to provide adequate protection to these secured lenders.' Westpoint at 51. Indeed, the District Court held that even if the ' 363(b) sale of assets was ultimately in the best economic interests of the debtor's constituencies because it was the best offer, that fact 'does not authorize the court to ignore the creditors' rights and the procedural requirements of Chapter 11.' Westpoint at 52.

The District Court concluded that the in-kind distribution to the first lien holders amounted to a fundamental restructuring of the estate that usurped Chapter 11's plan confirmation procedures in contravention of long-standing bankruptcy law. It distinguished cases cited by the Debtors on the basis that 'none involved transactions in derogation of affected creditors' interests.' The District Court held that the ' 363(b) sale and the distribution that followed fundamentally impaired the contractual rights of first lien holders to such an extent that the bankruptcy estate would be permanently altered if the distribution was upheld ' a result beyond the scope of a ' 363(b) sale.

The court also quickly dispensed with arguments that ' 105(a)'s broad- based equitable powers supplied the authority for an in-kind distribution. While noting that ' 105(a) was 'a powerful tool in connection with the reorganization of debtors and the realization of fresh starts, the District Court found it was 'not infinitely flexible' and did not permit bankruptcy courts to issue orders that were inconsistent with the Bankruptcy Code. The District Court found that the Sale Order's permanent impairment of first lien holders' substantive contract rights by forcing upon them in satisfaction of their claims equities rather than cash, outside the strictures of a Chapter 11 reorganization plan, was violative of the Code, and could not be salvaged by reference to the 'necessary or appropriate' language of ' 105(a).

Adequate Protection

The District Court also addressed the issue of whether the Intercreditor Agreement authorized distribution of securities to second lien holders when the first lien holders had not been paid in full in cash, under that agreement's 'adequate protection' clause. Under ' 2.4(g) of the Intercreditor Agreement, the second lien holders were permitted to seek adequate protection in accordance with Sections 361 through 364 of the Bankruptcy Code.

The District Court held that the bankruptcy court 'made no finding that any decrease in the value of the lenders' interests in the replacement collateral would result from the Debtors' retention of the replacement collateral pending confirmation of a plan or other appropriate conclusion of the bankruptcy proceedings.' Thus, the need for the adequate protection payments envisioned by ' 2.4(g) of the Intercreditor Agreement and the Bankruptcy Code was never triggered. Indeed, the District Court stated that no authority existed 'standing for the proposition that an action in permanent derogation of a senior creditor's contractual rights can be forced upon that creditor for the purpose of providing 'adequate protection' to a junior creditor.'

Ultimately, the District Court directed that the securities to be distributed to the first lien holders instead be sold on the open market ' with the cash proceeds of such sale to be paid to the first lien holders in satisfaction of their claims. The District Court also ordered the matter remanded to the bankruptcy court for further proceedings, directing that the securities allocated to the second lien holders under the Sale Order remain in escrow pending further order of the bankruptcy court.

Lessons Learned

What can we learn from In re Westpoint Stevens? At least a few lessons can be extracted from its holding. First, Westpoint Stevens augurs well for the preservation of the contractual rights of first lien holder rights to have their secured claims satisfied in the manner contemplated by their respective credit agreements. Indeed, the case stands for the proposition that first lien holders may insist upon the consideration called for in their contracts even if the alternate consideration offered may be equally valuable. This is so because the Bankruptcy Code does not allow for the impairment of such rights outside the plan confirmation process. Therefore, the holding provides an important protection for senior secured creditors, sending the message to others that any opportunity to alter contractual rights of a senior secured creditor can only be through resort to the rigorous requirements of the Chapter 11 plan confirmation process.

Westpoint Stevens also demonstrates that Sections 105(a) and 363(b) do not give courts carte blanche to fashion equitable remedies, even when such remedies may be economically justified. Westpoint makes it plain that when the contractual rights of first lien holders to receive cash consideration in satisfaction of their claims are altered, without the lien holders' consent, resort to Sections 105(a) and 363(b) will not vindicate such a fundamental impairment of rights. Indeed, the case makes plain that lien holders' contractual rights to claim satisfaction can only be altered, absent consent, through resort to the Bankruptcy Code's plan confirmation process.

Finally, the case may place a burden upon second lien holders to negotiate intercreditor agreements that address the issues raised by the holding of the case. Such provisions may include drafting intercreditor agreements to provide for the advance consent of first lien holders to ' 363(b) sales and potential in-kind distributions. Of course, the prospects of obtaining such major concessions from first lien holders in the wake of Westpoint Stevens are dubious at best. Without these concessions, however, second lien holders are likely to be forced to submit to the more protracted plan reorganization processes under the Code to affect a senior secured creditor's rights.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Seyfarth Shaw LLP. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected]. The author gratefully acknowledges the assistance of Carlos Bellidos, an associate at Seyfarth Shaw LLP, in the preparation of this article.

One of the leading issues currently faced by bankruptcy practitioners can be found in the frequently recurring disputes between first and second lienholders ' an issue that was recently addressed in the context of a ' 363 sale. In Contrarian Funds, LLC v. Westpoint Stevens, Inc. (In re Westpoint Stevens, Inc.), 333 B.R. 30 (S.D.N.Y. 2005), the United States District Court for the Southern District of New York (the District Court) reversed a ' 363(b) sale order (Sale Order) of the bankruptcy court on the grounds that the Sale Order authorized an in-kind distribution of equities ' rather than cash ' to first lien holders outside the Chapter 11 plan confirmation process. The District Court held that: 1) in-kind distributions impaired the contractual rights of first lien holders to cash consideration; 2) such distributions were not sanctioned by Sections 105(a) and 363(b) of the Bankruptcy Code; and 3) '[no] decrease in the value of the [second lien holders'] interests in the replacement collateral would result from the Debtors' retention of the replacement collateral pending confirmation of a plan or other appropriate conclusion of the bankruptcy proceedings.'

The secured creditors held perfected liens in Westpoint's assets. The Sale Order in Westpoint provided for the sale of the debtor's assets, free and clear of all liens. The Sale Order further provided that secured creditors were to receive cash and replacement liens in the purchaser's securities, and that the cash and securities were deemed to fully satisfy the secured creditors' claims, thus terminating their liens.

The first lien holders appealed the bankruptcy court's approval of the Sale Order, challenging the claim satisfaction and lien termination provisions on the grounds that they effectively converted their interests into an illiquid minority interest in the purchaser. Finding that the distribution provided for under the Sale Order could only take place within the confines of a plan of reorganization, the District Court rejected certain provisions of the Sale Order and remanded the matter to the bankruptcy court. (Ironically, earlier that year, a steering committee of the first lien holders, in collaboration with another entity, had negotiated a proposed transaction with the Debtors which was similar in structure to the transaction ultimately approved by the Sale Order. The proposed transaction would have allowed the Debtors' assets to be transferred under ' 363(b) of the Bankruptcy Code to an affiliate of the steering committee, with the Debtors receiving equity in the affiliate in return. That equity would have in turn been distributed in satisfaction of first lien holder debt, allowing the steering committee, as majority holders of the first lien debt, to control the new company. The bankruptcy court denied the proposed transaction in favor of the auction procedure.)

Background

The Debtors had entered Chapter 11 two years before, but had been unable to come to a consensus with their creditors on a Chapter 11 reorganization plan. The Debtors faced financial ruin ' lacking sufficient cash to retire their debtor-in-possession financing and the secured claims held by the first lien holders.

Facing this crisis, Westpoint held a sale of substantially all of its assets pursuant to a court-ordered auction. The Sale Order, approving the asset sale, was entered. The first lien holders moved for an expedited appeal of the Sale Order and entered into a stipulation that stayed distribution of any securities to the second lien holders. Those securities were placed in escrow. The remaining aspects of the sale, including the distribution of securities to the first lien holders, proceeded as contemplated under the Sale Order.

On appeal, the District Court found that the Sale Order impaired the contractual right of the first lien holders to have their claims fully satisfied in cash ' finding that a non-cash distribution to the first lien holders could only be accomplished through the Chapter 11 plan confirmation process. In reversing certain provisions of the Sale Order (but approving the distribution of cash and securities to satisfy the first lien holders' claims), the District Court rejected arguments that a distribution of securities to first lien holders was authorized by: 1) the first lien holders' Credit Agreement; or 2) Sections 363(b) and 105(a) of the Bankruptcy Code.

Impairment of Contractual Rights

The District Court first looked to the first lien holders' Credit Agreement to determine if it contained the requisite authority for the bankruptcy court's findings that the Debtors' obligations could be satisfied through a non-cash distribution to first lien holders other than by cash. The District Court found that the bankruptcy court had wholly misconstrued ' 3.15(c) of the Credit Agreement in finding that distribution of non-cash consideration was permitted. Reviewing the contract as a whole, the District Court found the bankruptcy court's holding 'inconsistent with the plain language of ' 3.15 of the Credit Agreement' which clearly mandated cash only claim satisfaction. Specifically, the District Court held that Sections 3.15 (a) and (b) of the Credit Agreement required the Debtors to satisfy their contractual obligations to the first lien holders' only through cash consideration. Further, the District Court found that ' 3.15(c) of the Credit Agreement simply changed the order in which cash payments were to be applied after a borrower defaulted, to ensure that expenses incurred in collecting the defaulted obligation were covered first.

Sections 363(b) and 105(a) of the Bankruptcy Code

The District Court then turned to an analysis of Sections 363(b) and 105(a) of the Bankruptcy Code to determine if those sections contained the requisite authority for a non-cash distribution to first lien holders. Section 363(b) of the Bankruptcy Code allows a court to approve the sale of assets of the estate outside the ordinary course of business, provided there is a good business reason to do so. The District Court did not question the bankruptcy court's finding that, because of the Debtor's precarious financial position, a good business reason existed for approving a ' 363(b) sale. However, the District Court found that 'the provision of claim satisfaction through the in-kind distribution is ' inconsistent with the Objecting First Lien Holders' contractual rights and is outside the scope of the bankruptcy court's power to provide adequate protection to these secured lenders.' Westpoint at 51. Indeed, the District Court held that even if the ' 363(b) sale of assets was ultimately in the best economic interests of the debtor's constituencies because it was the best offer, that fact 'does not authorize the court to ignore the creditors' rights and the procedural requirements of Chapter 11.' Westpoint at 52.

The District Court concluded that the in-kind distribution to the first lien holders amounted to a fundamental restructuring of the estate that usurped Chapter 11's plan confirmation procedures in contravention of long-standing bankruptcy law. It distinguished cases cited by the Debtors on the basis that 'none involved transactions in derogation of affected creditors' interests.' The District Court held that the ' 363(b) sale and the distribution that followed fundamentally impaired the contractual rights of first lien holders to such an extent that the bankruptcy estate would be permanently altered if the distribution was upheld ' a result beyond the scope of a ' 363(b) sale.

The court also quickly dispensed with arguments that ' 105(a)'s broad- based equitable powers supplied the authority for an in-kind distribution. While noting that ' 105(a) was 'a powerful tool in connection with the reorganization of debtors and the realization of fresh starts, the District Court found it was 'not infinitely flexible' and did not permit bankruptcy courts to issue orders that were inconsistent with the Bankruptcy Code. The District Court found that the Sale Order's permanent impairment of first lien holders' substantive contract rights by forcing upon them in satisfaction of their claims equities rather than cash, outside the strictures of a Chapter 11 reorganization plan, was violative of the Code, and could not be salvaged by reference to the 'necessary or appropriate' language of ' 105(a).

Adequate Protection

The District Court also addressed the issue of whether the Intercreditor Agreement authorized distribution of securities to second lien holders when the first lien holders had not been paid in full in cash, under that agreement's 'adequate protection' clause. Under ' 2.4(g) of the Intercreditor Agreement, the second lien holders were permitted to seek adequate protection in accordance with Sections 361 through 364 of the Bankruptcy Code.

The District Court held that the bankruptcy court 'made no finding that any decrease in the value of the lenders' interests in the replacement collateral would result from the Debtors' retention of the replacement collateral pending confirmation of a plan or other appropriate conclusion of the bankruptcy proceedings.' Thus, the need for the adequate protection payments envisioned by ' 2.4(g) of the Intercreditor Agreement and the Bankruptcy Code was never triggered. Indeed, the District Court stated that no authority existed 'standing for the proposition that an action in permanent derogation of a senior creditor's contractual rights can be forced upon that creditor for the purpose of providing 'adequate protection' to a junior creditor.'

Ultimately, the District Court directed that the securities to be distributed to the first lien holders instead be sold on the open market ' with the cash proceeds of such sale to be paid to the first lien holders in satisfaction of their claims. The District Court also ordered the matter remanded to the bankruptcy court for further proceedings, directing that the securities allocated to the second lien holders under the Sale Order remain in escrow pending further order of the bankruptcy court.

Lessons Learned

What can we learn from In re Westpoint Stevens? At least a few lessons can be extracted from its holding. First, Westpoint Stevens augurs well for the preservation of the contractual rights of first lien holder rights to have their secured claims satisfied in the manner contemplated by their respective credit agreements. Indeed, the case stands for the proposition that first lien holders may insist upon the consideration called for in their contracts even if the alternate consideration offered may be equally valuable. This is so because the Bankruptcy Code does not allow for the impairment of such rights outside the plan confirmation process. Therefore, the holding provides an important protection for senior secured creditors, sending the message to others that any opportunity to alter contractual rights of a senior secured creditor can only be through resort to the rigorous requirements of the Chapter 11 plan confirmation process.

Westpoint Stevens also demonstrates that Sections 105(a) and 363(b) do not give courts carte blanche to fashion equitable remedies, even when such remedies may be economically justified. Westpoint makes it plain that when the contractual rights of first lien holders to receive cash consideration in satisfaction of their claims are altered, without the lien holders' consent, resort to Sections 105(a) and 363(b) will not vindicate such a fundamental impairment of rights. Indeed, the case makes plain that lien holders' contractual rights to claim satisfaction can only be altered, absent consent, through resort to the Bankruptcy Code's plan confirmation process.

Finally, the case may place a burden upon second lien holders to negotiate intercreditor agreements that address the issues raised by the holding of the case. Such provisions may include drafting intercreditor agreements to provide for the advance consent of first lien holders to ' 363(b) sales and potential in-kind distributions. Of course, the prospects of obtaining such major concessions from first lien holders in the wake of Westpoint Stevens are dubious at best. Without these concessions, however, second lien holders are likely to be forced to submit to the more protracted plan reorganization processes under the Code to affect a senior secured creditor's rights.

Robert W. Dremluk, a member of this newsletter's Board of Editors, is a partner in the New York office of Seyfarth Shaw LLP. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected]. The author gratefully acknowledges the assistance of Carlos Bellidos, an associate at Seyfarth Shaw LLP, in the preparation of this article.