Intercreditor Agreements

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

One of the more intriguing aspects of working with intercreditor agreements is that the parties generally work with a blank canvas to craft a deal-specific agreement tailored to the relationship between the parties and the requirements of the transaction. Unlike other aspects of commercial finance practice, such as Uniform Commercial Code (“UCC”) financing statements, parties are not bound by required formats or limitations as to the structure and content of intercreditor agreements.

One of the perils of working in such an “open-air” arena, however, is that the parties may not contemplate or anticipate future events that could alter the relationship of the parties or affect the original purpose of the intercreditor agreement. While the effects of such events may be positive, neutral or negative (or some combination thereof), the unintended consequences have the potential to create future uncertainty. Among the main purposes for entering into an intercreditor agreement is to establish certainty as to the parties and their respective rights and obligations. Thus, while negotiating the trees of terms and conditions in an intercreditor agreement, the parties are advised to step back periodically and examine the relationship forest as a whole to ensure that the intercreditor agreement will continue to serve its intended purpose notwithstanding future changes in circumstances.

MG Financial Bank v. Paragon Mort.

The law of unintended consequences reared its head in MB Financial Bank v. Paragon Mort., 89 So. 3d 917 (Fla. Dist. Ct. App. 2012). In MB Financial, Paragon had made a loan to Fuel Investment and Development II, LLC (“Fuel”) secured by a mortgage lien on certain real property owned by the latter. Paragon also obtained guaranties from the four principals of Fuel. In November 2006, Fuel needed additional capital, and it obtained a loan from Broadway Bank (the predecessor to MB Financial Bank) secured by a mortgage lien on the same real property securing the Paragon loan. Broadway Bank obtained guaranties from the four principals of Fuel as additional credit support for the loan. A portion of the proceeds of the Broadway Bank loan was applied to pay down the Paragon loan.

In connection with the Broadway Bank loan, Paragon, Broadway Bank and Fuel entered into an intercreditor agreement. The parties agreed that Broadway Bank's lien on the real property would be senior and that Paragon's lien would be junior. The intercreditor agreement stated that Paragon would receive no payment from Fuel on its remaining indebtedness until the Broadway Bank loan was paid in full. Further, Paragon agreed to a standstill provision whereby Paragon would not institute any action against Fuel or the real property collateral until the Broadway Bank loan was paid in full.

In 2008, the Broadway Bank loan matured, but Fuel was unable to make the necessary payment. Two of the four guarantors agreed to form a new entity, Downtown St. Pete Properties, LLC (“Downtown Properties”), and to purchase the Broadway Bank loan. The purchase was funded with $1 million cash from Downtown Properties and with the balance in the form of a loan from Broadway Bank to Downtown Properties (secured by a security interest in the loan document purchased from Broadway Bank by Downtown Properties). Thus, the practical result was that two of the principals of Fuel now controlled the senior indebtedness owed by Fuel.

As a result, the two principals who owned Downtown Properties could effectively prohibit Paragon from taking action against Fuel or the real property collateral simply by keeping all or a portion of the senior loan outstanding. Clearly, this was not what Paragon, Fuel and Broadway Bank had intended when they entered into the intercreditor agreement. However, unintended consequences frequently work to the disadvantage of at least one party to a transaction.

The Court's Ruling

The appellate court confirmed that the standstill provision was effective and enforceable against Paragon as to Fuel and the real property collateral. The MB Financial court noted that the intercreditor agreement did not place any limitation on the ability of Broadway Bank to assign the loan to any party, including principals of Fuel. Further, the court held that the transfer of the Broadway Bank loan to Downtown Properties did not serve as a satisfaction of the original Broadway Bank loan (which would have freed Paragon from the limitations imposed by the standstill).

However, the law of unintended consequences was not quite finished. The MB Financial litigation commenced when Paragon filed suit against the four guarantors. Broadway Bank and Downtown Properties argued that the standstill provision in the intercreditor agreement prohibited Paragon from proceeding against the guarantors. The MB Financial court disagreed, pointing to the language of the intercreditor agreement. The standstill provision prohibited proceeding against or recovering from “Borrower” (defined as Fuel) or the real property collateral, and the definition of “Enforcement Action” referred only to proceedings against Fuel or the real property collateral.

Finally, the MB Financial court refused to interpret the subordination of “payments by or on behalf of [Fuel]” as a prohibition on obtaining a judgment against the guarantors. It should be noted that the court also stated that payments on any such judgment would be subject to the subordination provisions of the intercreditor agreement, a result with which some may take issue. However, that is another topic for another article.

In re Boston Generating, LLC

Not all unintended consequences are a result of unforeseen changes in circumstances. Sometimes minor drafting issues in an intercreditor agreement may lead to surprising results. In the case of In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010), the court illustrated the necessity of precise, express language, especially when dealing with the waiver of future rights in bankruptcy proceedings.

In Boston Generating, the debtors in a Chapter 11 case were operators of power generation facilities in Boston. The debtor's operations were financed by a senior loan facility (approximately $1.45 billion) and a junior loan facility (approximately $350 million), and both loan facilities were secured by essentially all assets of the debtors. [Note, in addition, the debtors also had an unsecured mezzanine facility of approximately $422 million, which is not relevant to this discussion.] The respective agents for the two secured loan facilities entered into an extensive intercreditor agreement delineating the relationship, rights and responsibilities of the two loan facilities.

In addition to establishing lien priority, the intercreditor agreement contained the following standstill provisions:

Until the Discharge of First Lien Obligations has occurred, whether or not any Insolvency or Liquidation Proceeding has been commenced ' the First Lien Collateral Agent, at the written direction of [First Lien Lenders holding a majority of the First Lien Debt], shall have the exclusive right to enforce rights, exercise remedies ' and make determinations regarding the release, sale, disposition or restrictions with respect to the Collateral without any consultation with or the consent of the Second Lien Collateral Agent or any Second Lien Secured Party ' provided that the Lien securing the Second Lien Obligations shall remain on the proceeds of such Collateral released or disposed of subject to the relative priorities described in Section 2.1[].

Without limiting the generality of the foregoing, unless and until the Discharge of First Lien Obligations has occurred, except as expressly provided in Sections 3.l(a)(i), 3.1(g) and 6.3(b) and this Section 3.1(c), the sole right of the Second Lien Collateral Agent, the Second Lien Administrative Agent, and any other Second Lien Secured Party with respect to the Collateral is to hold a Lien on the Collateral pursuant to the Second Lien Collateral Documents for the period and to the extent granted therein and to receive a share of the proceeds thereof, if any, after the Discharge of First Lien Obligations has occurred.

During the course of the Chapter 11 proceeding, a potential buyer for the assets of the debtors was identified. Accordingly, the bankruptcy court held a hearing to establish bid procedures for the anticipated sale under Section 363 of the Bankruptcy Code.

At the hearing, the second lien agent and second lien lenders objected to the proposed sale, as they believed delaying the sale for a few months until the beginning of the following year would result in a higher sale price. The first lien agent argued that the second lien agent and second lien lenders lacked standing to object to the bid procedures. The first lien agent stated that the plain language of the intercreditor agreement prohibited the second lien agent and second lien lenders from interfering with the sale process in any manner.

The Court's Ruling

The Boston Generating court rejected the standing argument of the first lien agent. The court indicated that while the intercreditor agreement expressly prohibited certain actions by the second lien agent and second lien lenders, the intercreditor agreement did not specifically prohibit objections to bidding procedures. Having established the standing of the second lien agent and second lien lenders to object to the bid procedures, the parties litigated the issue of whether the second lien agent and second lien lenders could object to the sale.

In reaching a decision, the Boston Generating court focused heavily on the use of the phrase “exercise of remedies” in the intercreditor agreement. At the sale hearing, the first lien agent and the second lien agent stipulated that actions to be taken by the first lien agent in connection with the proposed sale were not an “exercise of remedies” as used in the intercreditor agreement. [As an aside, it should be noted that the Boston Generating court also stated that it was otherwise inclined to find that consent to a sale under Section 363(f)(2) of the Bankruptcy Code is an exercise of rights granted to a secured party and does constitute an exercise of remedies. Thus, one must wonder if the outcome would have changed had the first lien agent not stipulated that actions to be taken by the first lien agent in connection with the proposed sale were not an "exercise of remedies" as used in the intercreditor agreement.]

In addition, the court found that the phrase “exercise of remedies” was not defined in the intercreditor agreement. Accordingly, absent an express waiver of consent rights under Section 363 of the Bankruptcy Code, the court was unwilling to impose a waiver. Moreover, the provisions of the intercreditor agreement permitted the second lien agent to make objections available to unsecured creditors. [Note, the first lien agent's position was not helped by the fact that the ABA Model Intercreditor Agreement contained a specific provision whereby the junior lienholder expressly waived its rights to object to a Section 363 sale.]

The court described the situation as a “perfect storm” of poor drafting, the scope of the waiver excluding rights to object as an unsecured creditor and the ill-advised stipulation of the first lien agent (though it appears that poor drafting was the primary cause of the issues in the case). Accordingly, the second lien agent and the second lien lenders were held to have standing to object to the proposed sale. While the court ultimately approved the sale, the process was undoubtedly longer and costlier than it should have been.

Conclusion

MB Financial and Boston Generating provide two examples of how the law of unintended consequences can create issues with intercreditor relationships. Of course, through the perfect lens of hindsight vision, the issues in each of these cases could have been avoided completely. Lenders (especially junior lenders) should consider whether an intercreditor agreement should prohibit assignments to principals and other insiders of a borrower entity (or whether the terms and conditions of the intercreditor agreement, including the standstill and subordination provisions, should automatically change upon any such assignment). Similarly, lenders (especially senior lenders) should ensure that other parties to an intercreditor agreement expressly and specifically waive any significant rights otherwise available to such parties.

More importantly, parties to an intercreditor agreement need to take a step back and think beyond the intercreditor agreement as merely one more item on a checklist which needs to be completed to close and fund a transaction. Rather, the parties need to remember that they may be in a transaction for the long haul and are better served working through potential issues in the documentation phase rather than in subsequent litigation.

Bradley J. Nielsen 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 in asset acquisitions, dispositions and financings, including loan and lease financings, syndications, securitizations, restructurings, workouts and bankruptcies. They may be reached at [email protected] and [email protected], respectively.

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

One of the more intriguing aspects of working with intercreditor agreements is that the parties generally work with a blank canvas to craft a deal-specific agreement tailored to the relationship between the parties and the requirements of the transaction. Unlike other aspects of commercial finance practice, such as Uniform Commercial Code (“UCC”) financing statements, parties are not bound by required formats or limitations as to the structure and content of intercreditor agreements.

One of the perils of working in such an “open-air” arena, however, is that the parties may not contemplate or anticipate future events that could alter the relationship of the parties or affect the original purpose of the intercreditor agreement. While the effects of such events may be positive, neutral or negative (or some combination thereof), the unintended consequences have the potential to create future uncertainty. Among the main purposes for entering into an intercreditor agreement is to establish certainty as to the parties and their respective rights and obligations. Thus, while negotiating the trees of terms and conditions in an intercreditor agreement, the parties are advised to step back periodically and examine the relationship forest as a whole to ensure that the intercreditor agreement will continue to serve its intended purpose notwithstanding future changes in circumstances.

MG Financial Bank v. Paragon Mort.

The law of unintended consequences reared its head in MB Financial Bank v. Paragon Mort. , 89 So. 3d 917 (Fla. Dist. Ct. App. 2012). In MB Financial, Paragon had made a loan to Fuel Investment and Development II, LLC (“Fuel”) secured by a mortgage lien on certain real property owned by the latter. Paragon also obtained guaranties from the four principals of Fuel. In November 2006, Fuel needed additional capital, and it obtained a loan from Broadway Bank (the predecessor to MB Financial Bank) secured by a mortgage lien on the same real property securing the Paragon loan. Broadway Bank obtained guaranties from the four principals of Fuel as additional credit support for the loan. A portion of the proceeds of the Broadway Bank loan was applied to pay down the Paragon loan.

In connection with the Broadway Bank loan, Paragon, Broadway Bank and Fuel entered into an intercreditor agreement. The parties agreed that Broadway Bank's lien on the real property would be senior and that Paragon's lien would be junior. The intercreditor agreement stated that Paragon would receive no payment from Fuel on its remaining indebtedness until the Broadway Bank loan was paid in full. Further, Paragon agreed to a standstill provision whereby Paragon would not institute any action against Fuel or the real property collateral until the Broadway Bank loan was paid in full.

In 2008, the Broadway Bank loan matured, but Fuel was unable to make the necessary payment. Two of the four guarantors agreed to form a new entity, Downtown St. Pete Properties, LLC (“Downtown Properties”), and to purchase the Broadway Bank loan. The purchase was funded with $1 million cash from Downtown Properties and with the balance in the form of a loan from Broadway Bank to Downtown Properties (secured by a security interest in the loan document purchased from Broadway Bank by Downtown Properties). Thus, the practical result was that two of the principals of Fuel now controlled the senior indebtedness owed by Fuel.

As a result, the two principals who owned Downtown Properties could effectively prohibit Paragon from taking action against Fuel or the real property collateral simply by keeping all or a portion of the senior loan outstanding. Clearly, this was not what Paragon, Fuel and Broadway Bank had intended when they entered into the intercreditor agreement. However, unintended consequences frequently work to the disadvantage of at least one party to a transaction.

The Court's Ruling

The appellate court confirmed that the standstill provision was effective and enforceable against Paragon as to Fuel and the real property collateral. The MB Financial court noted that the intercreditor agreement did not place any limitation on the ability of Broadway Bank to assign the loan to any party, including principals of Fuel. Further, the court held that the transfer of the Broadway Bank loan to Downtown Properties did not serve as a satisfaction of the original Broadway Bank loan (which would have freed Paragon from the limitations imposed by the standstill).

However, the law of unintended consequences was not quite finished. The MB Financial litigation commenced when Paragon filed suit against the four guarantors. Broadway Bank and Downtown Properties argued that the standstill provision in the intercreditor agreement prohibited Paragon from proceeding against the guarantors. The MB Financial court disagreed, pointing to the language of the intercreditor agreement. The standstill provision prohibited proceeding against or recovering from “Borrower” (defined as Fuel) or the real property collateral, and the definition of “Enforcement Action” referred only to proceedings against Fuel or the real property collateral.

Finally, the MB Financial court refused to interpret the subordination of “payments by or on behalf of [Fuel]” as a prohibition on obtaining a judgment against the guarantors. It should be noted that the court also stated that payments on any such judgment would be subject to the subordination provisions of the intercreditor agreement, a result with which some may take issue. However, that is another topic for another article.

In re Boston Generating, LLC

Not all unintended consequences are a result of unforeseen changes in circumstances. Sometimes minor drafting issues in an intercreditor agreement may lead to surprising results. In the case of In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010), the court illustrated the necessity of precise, express language, especially when dealing with the waiver of future rights in bankruptcy proceedings.

In Boston Generating, the debtors in a Chapter 11 case were operators of power generation facilities in Boston. The debtor's operations were financed by a senior loan facility (approximately $1.45 billion) and a junior loan facility (approximately $350 million), and both loan facilities were secured by essentially all assets of the debtors. [Note, in addition, the debtors also had an unsecured mezzanine facility of approximately $422 million, which is not relevant to this discussion.] The respective agents for the two secured loan facilities entered into an extensive intercreditor agreement delineating the relationship, rights and responsibilities of the two loan facilities.

In addition to establishing lien priority, the intercreditor agreement contained the following standstill provisions:

Until the Discharge of First Lien Obligations has occurred, whether or not any Insolvency or Liquidation Proceeding has been commenced ' the First Lien Collateral Agent, at the written direction of [First Lien Lenders holding a majority of the First Lien Debt], shall have the exclusive right to enforce rights, exercise remedies ' and make determinations regarding the release, sale, disposition or restrictions with respect to the Collateral without any consultation with or the consent of the Second Lien Collateral Agent or any Second Lien Secured Party ' provided that the Lien securing the Second Lien Obligations shall remain on the proceeds of such Collateral released or disposed of subject to the relative priorities described in Section 2.1[].

Without limiting the generality of the foregoing, unless and until the Discharge of First Lien Obligations has occurred, except as expressly provided in Sections 3.l(a)(i), 3.1(g) and 6.3(b) and this Section 3.1(c), the sole right of the Second Lien Collateral Agent, the Second Lien Administrative Agent, and any other Second Lien Secured Party with respect to the Collateral is to hold a Lien on the Collateral pursuant to the Second Lien Collateral Documents for the period and to the extent granted therein and to receive a share of the proceeds thereof, if any, after the Discharge of First Lien Obligations has occurred.

During the course of the Chapter 11 proceeding, a potential buyer for the assets of the debtors was identified. Accordingly, the bankruptcy court held a hearing to establish bid procedures for the anticipated sale under Section 363 of the Bankruptcy Code.

At the hearing, the second lien agent and second lien lenders objected to the proposed sale, as they believed delaying the sale for a few months until the beginning of the following year would result in a higher sale price. The first lien agent argued that the second lien agent and second lien lenders lacked standing to object to the bid procedures. The first lien agent stated that the plain language of the intercreditor agreement prohibited the second lien agent and second lien lenders from interfering with the sale process in any manner.

The Court's Ruling

The Boston Generating court rejected the standing argument of the first lien agent. The court indicated that while the intercreditor agreement expressly prohibited certain actions by the second lien agent and second lien lenders, the intercreditor agreement did not specifically prohibit objections to bidding procedures. Having established the standing of the second lien agent and second lien lenders to object to the bid procedures, the parties litigated the issue of whether the second lien agent and second lien lenders could object to the sale.

In reaching a decision, the Boston Generating court focused heavily on the use of the phrase “exercise of remedies” in the intercreditor agreement. At the sale hearing, the first lien agent and the second lien agent stipulated that actions to be taken by the first lien agent in connection with the proposed sale were not an “exercise of remedies” as used in the intercreditor agreement. [As an aside, it should be noted that the Boston Generating court also stated that it was otherwise inclined to find that consent to a sale under Section 363(f)(2) of the Bankruptcy Code is an exercise of rights granted to a secured party and does constitute an exercise of remedies. Thus, one must wonder if the outcome would have changed had the first lien agent not stipulated that actions to be taken by the first lien agent in connection with the proposed sale were not an "exercise of remedies" as used in the intercreditor agreement.]

In addition, the court found that the phrase “exercise of remedies” was not defined in the intercreditor agreement. Accordingly, absent an express waiver of consent rights under Section 363 of the Bankruptcy Code, the court was unwilling to impose a waiver. Moreover, the provisions of the intercreditor agreement permitted the second lien agent to make objections available to unsecured creditors. [Note, the first lien agent's position was not helped by the fact that the ABA Model Intercreditor Agreement contained a specific provision whereby the junior lienholder expressly waived its rights to object to a Section 363 sale.]

The court described the situation as a “perfect storm” of poor drafting, the scope of the waiver excluding rights to object as an unsecured creditor and the ill-advised stipulation of the first lien agent (though it appears that poor drafting was the primary cause of the issues in the case). Accordingly, the second lien agent and the second lien lenders were held to have standing to object to the proposed sale. While the court ultimately approved the sale, the process was undoubtedly longer and costlier than it should have been.

Conclusion

MB Financial and Boston Generating provide two examples of how the law of unintended consequences can create issues with intercreditor relationships. Of course, through the perfect lens of hindsight vision, the issues in each of these cases could have been avoided completely. Lenders (especially junior lenders) should consider whether an intercreditor agreement should prohibit assignments to principals and other insiders of a borrower entity (or whether the terms and conditions of the intercreditor agreement, including the standstill and subordination provisions, should automatically change upon any such assignment). Similarly, lenders (especially senior lenders) should ensure that other parties to an intercreditor agreement expressly and specifically waive any significant rights otherwise available to such parties.

More importantly, parties to an intercreditor agreement need to take a step back and think beyond the intercreditor agreement as merely one more item on a checklist which needs to be completed to close and fund a transaction. Rather, the parties need to remember that they may be in a transaction for the long haul and are better served working through potential issues in the documentation phase rather than in subsequent litigation.

Bradley J. Nielsen 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 in asset acquisitions, dispositions and financings, including loan and lease financings, syndications, securitizations, restructurings, workouts and bankruptcies. They may be reached at [email protected] and [email protected], respectively.