Beyond the Signed Agreement: Intercreditor Dynamics in Bankruptcy

The last 10 years have seen a significant growth in debt financing as a component of the balance sheet. This growth was facilitated in part by the dramatic expansion of second lien financing structures. Second lien financing allowed borrowers to unlock asset values by borrowing against assets that fell outside typical underwriting standards of traditional asset-based first lien lenders. At their inception, these loans were frequently referred to as “silent seconds,” a reference to the limits imposed on the second lien lenders through the intercreditor agreement. As the market for second lien debt grew, so did the second lien lenders' negotiating leverage and the complexity of the structures adopted. As a result, intercreditor agreements became far more complex, oftentimes incorporating concepts drawn from high-yield debt structures or mezzanine financing structures. The implications of these variations were not necessarily completely thought out when negotiated. Occasionally, the persons responsible for negotiating and drafting these agreements had little, if any, experience enforcing their terms in bankruptcy. As a result, intercreditor agreements sometimes contain terms that, while seemingly innocuous at the time they were drafted, can have significantly adverse consequences when applied in the course of a bankruptcy proceeding.

The essence of any intercreditor agreement is a set of terms related to subordination of the second lien facility. Typical subordination concepts governed by the intercreditor agreement include lien subordination, debt subordination, payment blockage periods following default, standstill periods on enforcement of remedies, deferral to enforcement by the senior creditor and a waterfall for application of any proceeds from enforcement.

A Bevy of Provisions

In addition to traditional concepts of subordination, intercreditor agreements almost always include a bevy of bankruptcy-related provisions. Intercreditor agreements usually include waivers or restrictions on the second lien lenders' ability during the course of a bankruptcy proceeding to: 1) demand adequate protection or interest payments, 2) object to the use of cash collateral by the debtor if authorized by the first lien lenders, 3) oppose terms of debtor-in-possession financing supported by the first lien lenders, 4) seek conversion to Chapter 7 or dismissal of the bankruptcy proceeding, 5) object to any sale of assets under ' 363 of the Bankruptcy Code that has been approved by the first lien lender, or 6) oppose any plan of reorganization supported by the first lien lenders. In furtherance of the first lien lenders' ability to control the terms of the plan or reorganization, intercreditor agreements usually also include provisions authorizing the first lien lenders to vote the claims of the second lien lenders.

From the first lien lenders' perspective, the objective of these provisions is to conform the actions of the second lien lenders to those of the first lien lenders in bankruptcy, hence the notion of the “silent second.” As the second lien market developed, so did the ability of the second lien lenders to pare down the restrictions of the intercreditor agreement. Over the course of the recent lending cycle, second lien lenders gained greater and greater leverage to negotiate the terms of intercreditor agreements. Second lien lenders used this leverage to resist or modify many of the waivers and restrictions commonly sought by first lien lenders in the intercreditor agreement with respect to bankruptcy.

Uncertain Enforceability

While the terms of the intercreditor agreement may have been exhaustively negotiated at the outset of the credit, their enforceability once bankruptcy arrives is less than certain. There are few reported decisions regarding enforcement of the bankruptcy-related provisions in intercreditor agreements, resulting in material uncertainties. A number of reported decisions have held that significant bankruptcy-related provisions in intercreditor agreements are unenforceable in bankruptcy. Two oft-cited examples are Bank of America v. 203 North LaSalle Street Ltd. P'shp (In re 203 North LaSalle Street Ltd. P'shp), 246 B.R. 325 Bankr. N.D. Ill. 2000) and In re Hart Ski Mfg. Co., Inc., 5 B.R. 734 (Bankr. D. Minn. 1980). In North LaSalle, the bankruptcy court held that the junior lender's right to vote on confirmation of a plan or reorganization could not be waived or assigned in a pre-bankruptcy intercreditor agreement. In Hart Ski, the bankruptcy court allowed a junior lender to seek adequate protection of its liens notwithstanding a pre-bankruptcy waiver in an intercreditor agreement. The rationale of these decisions and the courts that follow them is that while ' 510(a) of the Bankruptcy Code provides that subordination agreements are enforceable in a bankruptcy proceeding, these bankruptcy-related waivers go beyond subordination. The courts question whether Congress intended to allow parties to waive what they perceive as fundamental bankruptcy rights in an agreement negotiated outside of bankruptcy.

While there are reported bankruptcy decisions that uphold bankruptcy-related waivers (e.g., In re Curtis Center Limited Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996), uncertainty as to enforceability of these terms creates opportunity for parties to take positions and exert leverage despite seemingly explicit language in the intercreditor agreement to the contrary.

More importantly, the exigencies of the bankruptcy process frequently preclude parties from insisting on strict performance of an agreement according to all of its terms. Within days, if not hours, of the commencement of a bankruptcy case, issues related to use of cash collateral, adequate protection, debtor-in-possession financing, employee retention, critical vendors, and the like must be resolved if the debtor is going to continue to function within the confines of bankruptcy and if the going-concern value of a company is to be preserved. There is simply no time to litigate these issues to conclusion. Insistence on strict performance can result in forced layoffs, shutting down the business and conversion to a Chapter 7 liquidation. Usually the pressing need for a negotiated resolution forces concessions by each of the parties from the terms of the intercreditor agreement in order to keep the lights on.

In this environment, perceptions as to valuation may be more influential over the outcome than the terms of the intercreditor agreement. In a bankruptcy, the fulcrum security is the lowest ranking debt in the company's capital structure that is “in the money” such that it stands to receive a distribution of the company's reorganization value. It is, after all, the holder of the fulcrum security whose money is primarily at risk in the bankruptcy process. The bankruptcy court is often inclined to give deference to the views of the holders of the fulcrum security (who have the most at stake) as to how to maximize value in the course of the bankruptcy. Of course, these issues come up, outside of an arms-length sale between a willing buyer and seller, when valuation is more subjective than objective, giving the parties to an intercreditor agreement significant opportunity to maneuver in bankruptcy disputes.

In addition, the impetus for consensual resolution of matters in bankruptcy can give leverage to the spoiler. Its not uncommon for out-of-the-money second lien lenders to use their position to extract value in exchange for concessions to allow the case to proceed. Minimizing or maximizing these opportunities (depending on your perspective and objective) requires forethought and the ability to immediately muster plausible arguments or even admissible evidence to support your position. A premium can be paid for taking aggressive positions or anticipating and effectively responding with evidence to the aggressive positions asserted against you.

Where debt is actively traded, first lien lenders and second lien lenders alike may find opportunities to control the terms of any feasible plan of reorganization by trading into controlling or blocking positions in the other's debt. This tactic may be particularly attractive where debt trades at significant discounts that do not necessarily bear exact correlation to the way claims might be treated under competing plans of reorganization.

A Successful Strategy

A successful bankruptcy strategy for dealing with intercreditor issues should put the intercreditor agreement in context, account for all of the other factors that may influence the result, and allow for flexibility. The end result of most bankruptcy disputes is, after all, usually a negotiated resolution that allows competing interests to each maximize the value of their position. An effective strategy for dealing with intercreditor issues will typically look beyond the pre-negotiated terms, utilizing then-existing facts and circumstances to maximize leverage to reach an acceptable resolution with respect to the immediate issues at hand.

John D. Fredericks is a corporate partner in the San Francisco office of Winston & Strawn LLP. He concentrates his practice in bankruptcy, commercial lending, and finance. Fredericks' diverse practice includes the representation of investors, secured lenders, equipment and vendor financiers, and unsecured creditors in front-end financing transactions and workouts, restructurings, and bankruptcies. He may be reached at [email protected].

When a creditor enters the realm of bankruptcy, lenders often find that the many detailed provisions of an extensively negotiated intercreditor agreement are no longer controlling. On the contrary, the intercreditor agreement may have little influence on the outcome of many critical matters that arise in bankruptcy. Questions regarding enforceability of bankruptcy-related waivers limit their effectiveness. Moreover, the exigent circumstances created by bankruptcy oftentimes mean that the written agreement is but one of many factors affecting outcome of intercreditor disputes in bankruptcy. Valuation, inter-facility claims trading, alignment of other claims and interests, among other things, further impact resolution of intercreditor issues. A considered strategy that accounts for all these various matters, coupled with flexible execution, is the key to maximizing position when the intercreditor relationship is subsumed by the bankruptcy of the borrower.

In anticipation of a bankruptcy proceeding, careful review of the particular terms of the intercreditor agreement is necessary to establish the parameters of the likely disputes, but the specific circumstances of the debtor should be incorporated in the strategies and responses that will affect the outcome of bankruptcy-related issues.

Significant Growth in Debt Financing

The last 10 years have seen a significant growth in debt financing as a component of the balance sheet. This growth was facilitated in part by the dramatic expansion of second lien financing structures. Second lien financing allowed borrowers to unlock asset values by borrowing against assets that fell outside typical underwriting standards of traditional asset-based first lien lenders. At their inception, these loans were frequently referred to as “silent seconds,” a reference to the limits imposed on the second lien lenders through the intercreditor agreement. As the market for second lien debt grew, so did the second lien lenders' negotiating leverage and the complexity of the structures adopted. As a result, intercreditor agreements became far more complex, oftentimes incorporating concepts drawn from high-yield debt structures or mezzanine financing structures. The implications of these variations were not necessarily completely thought out when negotiated. Occasionally, the persons responsible for negotiating and drafting these agreements had little, if any, experience enforcing their terms in bankruptcy. As a result, intercreditor agreements sometimes contain terms that, while seemingly innocuous at the time they were drafted, can have significantly adverse consequences when applied in the course of a bankruptcy proceeding.

The essence of any intercreditor agreement is a set of terms related to subordination of the second lien facility. Typical subordination concepts governed by the intercreditor agreement include lien subordination, debt subordination, payment blockage periods following default, standstill periods on enforcement of remedies, deferral to enforcement by the senior creditor and a waterfall for application of any proceeds from enforcement.

A Bevy of Provisions

In addition to traditional concepts of subordination, intercreditor agreements almost always include a bevy of bankruptcy-related provisions. Intercreditor agreements usually include waivers or restrictions on the second lien lenders' ability during the course of a bankruptcy proceeding to: 1) demand adequate protection or interest payments, 2) object to the use of cash collateral by the debtor if authorized by the first lien lenders, 3) oppose terms of debtor-in-possession financing supported by the first lien lenders, 4) seek conversion to Chapter 7 or dismissal of the bankruptcy proceeding, 5) object to any sale of assets under ' 363 of the Bankruptcy Code that has been approved by the first lien lender, or 6) oppose any plan of reorganization supported by the first lien lenders. In furtherance of the first lien lenders' ability to control the terms of the plan or reorganization, intercreditor agreements usually also include provisions authorizing the first lien lenders to vote the claims of the second lien lenders.

From the first lien lenders' perspective, the objective of these provisions is to conform the actions of the second lien lenders to those of the first lien lenders in bankruptcy, hence the notion of the “silent second.” As the second lien market developed, so did the ability of the second lien lenders to pare down the restrictions of the intercreditor agreement. Over the course of the recent lending cycle, second lien lenders gained greater and greater leverage to negotiate the terms of intercreditor agreements. Second lien lenders used this leverage to resist or modify many of the waivers and restrictions commonly sought by first lien lenders in the intercreditor agreement with respect to bankruptcy.

Uncertain Enforceability

While the terms of the intercreditor agreement may have been exhaustively negotiated at the outset of the credit, their enforceability once bankruptcy arrives is less than certain. There are few reported decisions regarding enforcement of the bankruptcy-related provisions in intercreditor agreements, resulting in material uncertainties. A number of reported decisions have held that significant bankruptcy-related provisions in intercreditor agreements are unenforceable in bankruptcy. Two oft-cited examples are Bank of America v. 203 North LaSalle Street Ltd. P'shp (In re 203 North LaSalle Street Ltd. P'shp), 246 B.R. 325 Bankr. N.D. Ill. 2000) and In re Hart Ski Mfg. Co., Inc., 5 B.R. 734 (Bankr. D. Minn. 1980). In North LaSalle, the bankruptcy court held that the junior lender's right to vote on confirmation of a plan or reorganization could not be waived or assigned in a pre-bankruptcy intercreditor agreement. In Hart Ski, the bankruptcy court allowed a junior lender to seek adequate protection of its liens notwithstanding a pre-bankruptcy waiver in an intercreditor agreement. The rationale of these decisions and the courts that follow them is that while ' 510(a) of the Bankruptcy Code provides that subordination agreements are enforceable in a bankruptcy proceeding, these bankruptcy-related waivers go beyond subordination. The courts question whether Congress intended to allow parties to waive what they perceive as fundamental bankruptcy rights in an agreement negotiated outside of bankruptcy.

While there are reported bankruptcy decisions that uphold bankruptcy-related waivers (e.g., In re Curtis Center Limited Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996), uncertainty as to enforceability of these terms creates opportunity for parties to take positions and exert leverage despite seemingly explicit language in the intercreditor agreement to the contrary.

More importantly, the exigencies of the bankruptcy process frequently preclude parties from insisting on strict performance of an agreement according to all of its terms. Within days, if not hours, of the commencement of a bankruptcy case, issues related to use of cash collateral, adequate protection, debtor-in-possession financing, employee retention, critical vendors, and the like must be resolved if the debtor is going to continue to function within the confines of bankruptcy and if the going-concern value of a company is to be preserved. There is simply no time to litigate these issues to conclusion. Insistence on strict performance can result in forced layoffs, shutting down the business and conversion to a Chapter 7 liquidation. Usually the pressing need for a negotiated resolution forces concessions by each of the parties from the terms of the intercreditor agreement in order to keep the lights on.

In this environment, perceptions as to valuation may be more influential over the outcome than the terms of the intercreditor agreement. In a bankruptcy, the fulcrum security is the lowest ranking debt in the company's capital structure that is “in the money” such that it stands to receive a distribution of the company's reorganization value. It is, after all, the holder of the fulcrum security whose money is primarily at risk in the bankruptcy process. The bankruptcy court is often inclined to give deference to the views of the holders of the fulcrum security (who have the most at stake) as to how to maximize value in the course of the bankruptcy. Of course, these issues come up, outside of an arms-length sale between a willing buyer and seller, when valuation is more subjective than objective, giving the parties to an intercreditor agreement significant opportunity to maneuver in bankruptcy disputes.

In addition, the impetus for consensual resolution of matters in bankruptcy can give leverage to the spoiler. Its not uncommon for out-of-the-money second lien lenders to use their position to extract value in exchange for concessions to allow the case to proceed. Minimizing or maximizing these opportunities (depending on your perspective and objective) requires forethought and the ability to immediately muster plausible arguments or even admissible evidence to support your position. A premium can be paid for taking aggressive positions or anticipating and effectively responding with evidence to the aggressive positions asserted against you.

Where debt is actively traded, first lien lenders and second lien lenders alike may find opportunities to control the terms of any feasible plan of reorganization by trading into controlling or blocking positions in the other's debt. This tactic may be particularly attractive where debt trades at significant discounts that do not necessarily bear exact correlation to the way claims might be treated under competing plans of reorganization.

A Successful Strategy

A successful bankruptcy strategy for dealing with intercreditor issues should put the intercreditor agreement in context, account for all of the other factors that may influence the result, and allow for flexibility. The end result of most bankruptcy disputes is, after all, usually a negotiated resolution that allows competing interests to each maximize the value of their position. An effective strategy for dealing with intercreditor issues will typically look beyond the pre-negotiated terms, utilizing then-existing facts and circumstances to maximize leverage to reach an acceptable resolution with respect to the immediate issues at hand.

John D. Fredericks is a corporate partner in the San Francisco office of Winston & Strawn LLP. He concentrates his practice in bankruptcy, commercial lending, and finance. Fredericks' diverse practice includes the representation of investors, secured lenders, equipment and vendor financiers, and unsecured creditors in front-end financing transactions and workouts, restructurings, and bankruptcies. He may be reached at [email protected].