Intercreditor Agreements

Editor's Note: This is the first article in a series covering various aspects of intercreditor agreements.

Intercreditor agreements can be both an important and a frustrating aspect of a commercial finance transaction. They provide attorneys and clients with a broad range of structuring and drafting options. Truly, an agreement may be built from scratch on every deal (though most attorneys will rely on a host of tried-and-true forms and clauses tailored to the specific issues at hand). On the other hand, intercreditor agreements often involve third parties who have no stake in the proposed financing or who are otherwise unwilling to provide any accommodation.

An easy solution would be for a single lender to handle all of the financing for a particular borrower. However, in today's market, with the lender's emphasis on spreading risk concentration and the borrower's emphasis on obtaining the most competitive rates, the typical borrower works with multiple lenders. In addition, especially in the era of private equity, while a borrower may work exclusively with a particular lender for discrete transactions, that borrower may be party to a broader senior credit facility. Furthermore, lenders that provide financing secured by inventory and accounts receivable (typically, revolving lines of credit with a borrowing base determined by a percentage of current assets) may require certain accommodations from the lender secured by the hard assets such as real estate, equipment and fixtures.

The end result is that intercreditor agreements are becoming more common in commercial finance transactions, even in the middle- and small-ticket arenas. By understanding the common intercreditor scenarios and the common intercreditor issues, however, attorneys can protect their clients' interests without derailing a transaction.

Typical Scenarios

Three typical scenarios fall under the broad umbrella of intercreditor relationships. The first is where a party providing new financing seeks confirmation of exclusive rights in certain collateral, or a disclaimer of interest in such collateral from an existing secured party. This is often a situation involving discrete financing to a borrower subject to a senior credit facility secured by substantially all assets (i.e., a lien on specific assets versus a blanket lien).

The second scenario is where competing lenders have (and will continue to have) a common interest in all or some of the collateral. This relationship can arise under a variety of paradigms, including a lien on specific assets versus a lien on specific assets (rare, but sometimes arising in connection with separate financing for similar discrete product lines which have certain common elements); a lien on specific assets versus a blanket lien (discrete financing to a borrower subject to a senior credit facility secured by substantially all assets); a blanket lien versus a blanket lien (such as a senior credit facility from a bank or syndicate group and a junior credit facility from a private equity sponsor or mezzanine lender); or common collateral allocated to a group of secured parties (as is common with a syndicate group of lenders in a credit facility).

The third situation involves what are commonly called “access agreements.” As noted above, the parties are usually a lender providing a revolving line of credit secured by raw materials, inventory and accounts receivable and a lender providing term financing secured by the plant where such raw materials are converted to inventory.

Identifying the relationship between the parties is the first step in determining what issues are likely to arise during drafting and negotiation of the intercreditor agreement. The interests of the lender secured by discrete collateral will differ greatly from the interests of the lender secured by all assets and from the lender secured by current assets. This article examines some of the common issues of traditional intercreditor agreements. Future articles will further examine specific intercreditor relationships, issues peculiar to those relationships and holdings of courts examining those relationships.

Senior and Junior Creditors

One of the two main purposes of an intercreditor agreement between competing creditors with interests in the same collateral is to establish priority in that collateral. The party with the senior interest in the collateral wants to clearly identify its priority collateral, and subordinate rights of the junior party in and to such collateral to the rights of the senior party. Some intercreditor agreements will run in one direction. The senior party will have a first priority interest in certain collateral (and nothing else), and the junior party will subordinate its interest in such collateral (and nothing else). In other intercreditor agreements, the parties may have senior and junior roles with respect to different pools of collateral, usually on a reciprocal basis.

Thus, the first secured party will have a senior interest in collateral pool “A” and a junior interest in collateral pool “B.” The second secured party will have a junior interest in collateral pool “A” and a senior interest in collateral pool “B.” Further, either or both parties may also have additional collateral pools in which the other party disclaims or releases any interest. Whatever the case, the intercreditor agreement should identify each pool of collateral and the priority of each party's interest in each such pool. Additionally, the intercreditor agreement should state that such agreement as to priority governs notwithstanding the order, timing or manner of attachment, perfection, filing, recording or other actions taken by either party with respect to its lien on the collateral.

Part and parcel with priority, the other main purpose of an intercreditor agreement is to impose a standstill on the junior creditor. For example, even if the parties clearly identify the priority collateral and the parties' respective rights therein, nothing prevents the junior creditor from exercising rights against the priority collateral. This situation is generally unacceptable to the senior creditor as any action taken against collateral by the junior creditor effectively forces the senior creditor to exercise remedies, even if the transaction to which the senior creditor is otherwise not subject to a default.

Thus, a senior creditor may be forced to put a performing account in default. To prevent junior creditors from instituting any actions against the priority collateral, the intercreditor agreement should contain a standstill clause. The standstill clause prohibits the junior creditor from exercising remedies against the collateral absent the prior written consent of the senior creditor. Some standstill clauses are absolute, others are generally absolute but subject to limited exceptions, and others are further limited by a finite standstill period. Future articles will delve deeper into the various types of standstill clauses, including exceptions thereto and common issues therewith.

Establishing Priority

Another issue with respect to intercreditor agreements is the validity of the agreement as to priority between the senior creditor and the junior creditor. Ideally, especially from the senior creditor's perspective, the agreement between the senior creditor and the junior creditor as to priority will be valid and enforceable notwithstanding any defect in, or non-perfection, setting aside, or avoidance of, the lien on the collateral (or the related loan documents). However, junior creditors will often assert that the agreement as to priority applies only to the extent the senior creditor has a valid, perfected and enforceable security interest in and lien on the collateral.

Intercreditor agreements frequently contain another provision related to priority and validity. Such a provision prohibits the junior creditor from challenging the senior creditor's lien on the collateral or the enforceability of the senior creditor's loan documents. In cases where the parties limit the agreement as to priority in the intercreditor agreement to the extent the senior creditor has a valid, perfected and enforceable security interest in and lien on the collateral, the senior creditor will likely require the prohibition on challenges to perfection and enforceability.

Since intercreditor agreements may apply to deals of varying maturities, they may contain provisions relating to amendments. Typically, these provisions will be more restrictive with respect to the junior creditor, but it is not uncommon to see some limits on the senior creditor as well. The most common relationships giving rise to restrictions on amendments involve senior and subordinate credit facilities secured by substantially all assets of a borrower (or borrower group); however, any intercreditor relationship may give rise to such limitations.

Typically, a creditor will request all or some of the following amendments: changes in the dollar amount of secured obligations (especially with respect to the senior obligations, as this would reduce the “equity” available to the junior creditor); changes in the interest rate, margin or fees; changes in scheduled amortization or maturity date; adding mandatory prepayments; changes imposing more restrictive covenants or more onerous obligations (especially with respect to the junior obligations, unless corresponding changes are made to the senior obligations); and granting additional rights adverse to the other creditor (especially with respect to the junior obligations). Please note that some of these prohibitions spill over into the debt subordination arena. Debt subordination agreements and intercreditor agreements often work hand-in-hand, especially in transactions involving senior and subordinate facilities.

Notice and Cure Rights

Two more related aspects of intercreditor agreements are notice rights and cure rights. Most intercreditor agreements have a provision stating that each creditor will give notice to the other creditor upon the occurrence of a default under such creditor's obligations or such creditor's exercise of remedies against the borrower or the collateral. On some occasions, giving notice is required prior to exercising remedies (though this requirement should typically be limited to situations where the junior creditor has the right to cure a default under the senior creditor's obligations).

The two primary cure rights are a creditor's right to cure a default and a creditor's right to purchase the other creditor's obligations. Cure rights and purchase rights are usually vested in a junior creditor, though in some situations a senior creditor will want cure rights or purchase rights as well (especially in transactions where the junior creditor is not subject to an absolute, indefinite standstill).

Usually, cure rights relate to defaults that can be cured by the payment of money or defaults that require performance or other non-monetary actions. Defaults that can be cured by the payment of money will tend to have shorter cure periods, while defaults that require performance or other non-monetary actions will tend to have longer cure periods. Such longer cure periods may also include one or more extensions or even an indefinite extension if the party facilitating the cure is undertaking continuous and commercially reasonable (or diligent) efforts to cure the default.

With respect to purchase rights, the intercreditor agreement should set forth the specific circumstances under which one creditor may purchase the other creditor's obligations, such as payment defaults, acceleration of the obligations and commencement of a bankruptcy proceeding by or against the borrower. In addition, the intercreditor agreement should clearly state the respective time periods for the purchasing creditor to elect and to consummate the purchase, whether the purchase is at par or if any applicable prepayment fees or make-whole amounts are payable and whether the non-purchasing creditor is prohibited from exercising remedies between the time of receiving notice of the election to purchase and the time of consummation of the purchase.

Conclusion

We hope this article has provided a useful summary of the more common relationships giving rise to intercreditor agreements and the more common issues that arise during the course of drafting and negotiating intercreditor agreements. As noted above, in future installments of this series, we will discuss other aspects of intercreditor agreements in greater detail, including disclaimers of interest, access agreements and bankruptcy issues relating to intercreditor agreements. We will also highlight judicial decisions involving interpretation and enforcement of intercreditor agreements.

Bradley J. Nielsen, a member of this newsletter's Board of Editors,'and Sean M. Gillen are partners in the Omaha, NE, office of Kutak Rock LLP. Nielsen represents lenders in connection with taxable and tax-exempt financings of a variety of commercial and governmental projects. Gillen is a member of the firm's Corporate Department, representing borrowers, lessees, lenders, lessors and credit enhancers. They may be reached at [email protected] and [email protected], respectively.

Editor's Note: This is the first article in a series covering various aspects of intercreditor agreements.

Intercreditor agreements can be both an important and a frustrating aspect of a commercial finance transaction. They provide attorneys and clients with a broad range of structuring and drafting options. Truly, an agreement may be built from scratch on every deal (though most attorneys will rely on a host of tried-and-true forms and clauses tailored to the specific issues at hand). On the other hand, intercreditor agreements often involve third parties who have no stake in the proposed financing or who are otherwise unwilling to provide any accommodation.

An easy solution would be for a single lender to handle all of the financing for a particular borrower. However, in today's market, with the lender's emphasis on spreading risk concentration and the borrower's emphasis on obtaining the most competitive rates, the typical borrower works with multiple lenders. In addition, especially in the era of private equity, while a borrower may work exclusively with a particular lender for discrete transactions, that borrower may be party to a broader senior credit facility. Furthermore, lenders that provide financing secured by inventory and accounts receivable (typically, revolving lines of credit with a borrowing base determined by a percentage of current assets) may require certain accommodations from the lender secured by the hard assets such as real estate, equipment and fixtures.

The end result is that intercreditor agreements are becoming more common in commercial finance transactions, even in the middle- and small-ticket arenas. By understanding the common intercreditor scenarios and the common intercreditor issues, however, attorneys can protect their clients' interests without derailing a transaction.

Typical Scenarios

Three typical scenarios fall under the broad umbrella of intercreditor relationships. The first is where a party providing new financing seeks confirmation of exclusive rights in certain collateral, or a disclaimer of interest in such collateral from an existing secured party. This is often a situation involving discrete financing to a borrower subject to a senior credit facility secured by substantially all assets (i.e., a lien on specific assets versus a blanket lien).

The second scenario is where competing lenders have (and will continue to have) a common interest in all or some of the collateral. This relationship can arise under a variety of paradigms, including a lien on specific assets versus a lien on specific assets (rare, but sometimes arising in connection with separate financing for similar discrete product lines which have certain common elements); a lien on specific assets versus a blanket lien (discrete financing to a borrower subject to a senior credit facility secured by substantially all assets); a blanket lien versus a blanket lien (such as a senior credit facility from a bank or syndicate group and a junior credit facility from a private equity sponsor or mezzanine lender); or common collateral allocated to a group of secured parties (as is common with a syndicate group of lenders in a credit facility).

The third situation involves what are commonly called “access agreements.” As noted above, the parties are usually a lender providing a revolving line of credit secured by raw materials, inventory and accounts receivable and a lender providing term financing secured by the plant where such raw materials are converted to inventory.

Identifying the relationship between the parties is the first step in determining what issues are likely to arise during drafting and negotiation of the intercreditor agreement. The interests of the lender secured by discrete collateral will differ greatly from the interests of the lender secured by all assets and from the lender secured by current assets. This article examines some of the common issues of traditional intercreditor agreements. Future articles will further examine specific intercreditor relationships, issues peculiar to those relationships and holdings of courts examining those relationships.

Senior and Junior Creditors

One of the two main purposes of an intercreditor agreement between competing creditors with interests in the same collateral is to establish priority in that collateral. The party with the senior interest in the collateral wants to clearly identify its priority collateral, and subordinate rights of the junior party in and to such collateral to the rights of the senior party. Some intercreditor agreements will run in one direction. The senior party will have a first priority interest in certain collateral (and nothing else), and the junior party will subordinate its interest in such collateral (and nothing else). In other intercreditor agreements, the parties may have senior and junior roles with respect to different pools of collateral, usually on a reciprocal basis.

Thus, the first secured party will have a senior interest in collateral pool “A” and a junior interest in collateral pool “B.” The second secured party will have a junior interest in collateral pool “A” and a senior interest in collateral pool “B.” Further, either or both parties may also have additional collateral pools in which the other party disclaims or releases any interest. Whatever the case, the intercreditor agreement should identify each pool of collateral and the priority of each party's interest in each such pool. Additionally, the intercreditor agreement should state that such agreement as to priority governs notwithstanding the order, timing or manner of attachment, perfection, filing, recording or other actions taken by either party with respect to its lien on the collateral.

Part and parcel with priority, the other main purpose of an intercreditor agreement is to impose a standstill on the junior creditor. For example, even if the parties clearly identify the priority collateral and the parties' respective rights therein, nothing prevents the junior creditor from exercising rights against the priority collateral. This situation is generally unacceptable to the senior creditor as any action taken against collateral by the junior creditor effectively forces the senior creditor to exercise remedies, even if the transaction to which the senior creditor is otherwise not subject to a default.

Thus, a senior creditor may be forced to put a performing account in default. To prevent junior creditors from instituting any actions against the priority collateral, the intercreditor agreement should contain a standstill clause. The standstill clause prohibits the junior creditor from exercising remedies against the collateral absent the prior written consent of the senior creditor. Some standstill clauses are absolute, others are generally absolute but subject to limited exceptions, and others are further limited by a finite standstill period. Future articles will delve deeper into the various types of standstill clauses, including exceptions thereto and common issues therewith.

Establishing Priority

Another issue with respect to intercreditor agreements is the validity of the agreement as to priority between the senior creditor and the junior creditor. Ideally, especially from the senior creditor's perspective, the agreement between the senior creditor and the junior creditor as to priority will be valid and enforceable notwithstanding any defect in, or non-perfection, setting aside, or avoidance of, the lien on the collateral (or the related loan documents). However, junior creditors will often assert that the agreement as to priority applies only to the extent the senior creditor has a valid, perfected and enforceable security interest in and lien on the collateral.

Intercreditor agreements frequently contain another provision related to priority and validity. Such a provision prohibits the junior creditor from challenging the senior creditor's lien on the collateral or the enforceability of the senior creditor's loan documents. In cases where the parties limit the agreement as to priority in the intercreditor agreement to the extent the senior creditor has a valid, perfected and enforceable security interest in and lien on the collateral, the senior creditor will likely require the prohibition on challenges to perfection and enforceability.

Since intercreditor agreements may apply to deals of varying maturities, they may contain provisions relating to amendments. Typically, these provisions will be more restrictive with respect to the junior creditor, but it is not uncommon to see some limits on the senior creditor as well. The most common relationships giving rise to restrictions on amendments involve senior and subordinate credit facilities secured by substantially all assets of a borrower (or borrower group); however, any intercreditor relationship may give rise to such limitations.

Typically, a creditor will request all or some of the following amendments: changes in the dollar amount of secured obligations (especially with respect to the senior obligations, as this would reduce the “equity” available to the junior creditor); changes in the interest rate, margin or fees; changes in scheduled amortization or maturity date; adding mandatory prepayments; changes imposing more restrictive covenants or more onerous obligations (especially with respect to the junior obligations, unless corresponding changes are made to the senior obligations); and granting additional rights adverse to the other creditor (especially with respect to the junior obligations). Please note that some of these prohibitions spill over into the debt subordination arena. Debt subordination agreements and intercreditor agreements often work hand-in-hand, especially in transactions involving senior and subordinate facilities.

Notice and Cure Rights

Two more related aspects of intercreditor agreements are notice rights and cure rights. Most intercreditor agreements have a provision stating that each creditor will give notice to the other creditor upon the occurrence of a default under such creditor's obligations or such creditor's exercise of remedies against the borrower or the collateral. On some occasions, giving notice is required prior to exercising remedies (though this requirement should typically be limited to situations where the junior creditor has the right to cure a default under the senior creditor's obligations).

The two primary cure rights are a creditor's right to cure a default and a creditor's right to purchase the other creditor's obligations. Cure rights and purchase rights are usually vested in a junior creditor, though in some situations a senior creditor will want cure rights or purchase rights as well (especially in transactions where the junior creditor is not subject to an absolute, indefinite standstill).

Usually, cure rights relate to defaults that can be cured by the payment of money or defaults that require performance or other non-monetary actions. Defaults that can be cured by the payment of money will tend to have shorter cure periods, while defaults that require performance or other non-monetary actions will tend to have longer cure periods. Such longer cure periods may also include one or more extensions or even an indefinite extension if the party facilitating the cure is undertaking continuous and commercially reasonable (or diligent) efforts to cure the default.

With respect to purchase rights, the intercreditor agreement should set forth the specific circumstances under which one creditor may purchase the other creditor's obligations, such as payment defaults, acceleration of the obligations and commencement of a bankruptcy proceeding by or against the borrower. In addition, the intercreditor agreement should clearly state the respective time periods for the purchasing creditor to elect and to consummate the purchase, whether the purchase is at par or if any applicable prepayment fees or make-whole amounts are payable and whether the non-purchasing creditor is prohibited from exercising remedies between the time of receiving notice of the election to purchase and the time of consummation of the purchase.

Conclusion

We hope this article has provided a useful summary of the more common relationships giving rise to intercreditor agreements and the more common issues that arise during the course of drafting and negotiating intercreditor agreements. As noted above, in future installments of this series, we will discuss other aspects of intercreditor agreements in greater detail, including disclaimers of interest, access agreements and bankruptcy issues relating to intercreditor agreements. We will also highlight judicial decisions involving interpretation and enforcement of intercreditor agreements.

Bradley J. Nielsen, a member of this newsletter's Board of Editors,'and Sean M. Gillen are partners in the Omaha, NE, office of Kutak Rock LLP. Nielsen represents lenders in connection with taxable and tax-exempt financings of a variety of commercial and governmental projects. Gillen is a member of the firm's Corporate Department, representing borrowers, lessees, lenders, lessors and credit enhancers. They may be reached at [email protected] and [email protected], respectively.