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A typical second lien bank loan is secured by a lien on substantially all of the borrower's assets. In most cases the second lien lenders will be sharing the capital structure with at least one other credit facility of the more traditional variety secured by a first lien on substantially the same collateral. The second lien loan is "second" because the two classes of creditors agree that, in the event any of the collateral is ever sold, whether in a bankruptcy proceeding or otherwise, the first lien indebtedness will receive payment in full before proceeds of the collateral will be distributed to the second lien lenders. The second lien loan is not contractually subordinated in the traditional sense (i.e., payment subordination), but it is subordinated in its claim to the proceeds of the collateral.
The terms of a "typical" second lien deal are becoming better settled, at least in the market for broadly syndicated loans. The relative rights of the first lien lenders and the second lien lenders are documented in an intercreditor agreement. Issues arising in the negotiation of intercreditor agreements involve both pre-bankruptcy filing and post-bankruptcy filing rights. The following discussion is limited to second lien bank financings. In second lien bond financings, these issues are often resolved differently.
Pre Bankruptcy Filing
The maximum amount of first lien indebtedness is typically negotiated. The market convention is to cap the amount of first lien indebtedness at a set dollar amount. The areas of controversy are related to whether or not the first lien indebtedness (i) "ratchets down", i.e., decreases as the term loan amortizes or if the term loans and revolving loans are partially paid down with the proceeds of collateral (with a permanent reduction in commitments) and (ii) includes a cushion to allow for incremental advances. Currently, there is no clear consensus as to these issues and such issues are dealt with on a deal-by-deal basis.
Most intercreditor agreements include a period of time during which second lien lenders must refrain from exercising certain of their rights and remedies with respect to the collateral. This period of time is generally referred to as a "standstill period." While the concept of a standstill period is common, the duration of that period is often a fiercely negotiated issue. The market for standstill periods currently ranges from 45 to 180 days. In addition, it is not uncommon to see a sliding scale whereby the standstill period for a payment default is shorter than the standstill period for a technical covenant default. Apart from the standstill provisions, most second lien deals preserve the rights and remedies that would be available to the second lien lenders as unsecured creditors, with a few exceptions.
The first and second lien lenders will negotiate their rights to amend their respective credit agreements without consent. Areas that typically require consent relate to increases in the first lien indebtedness (in excess of the overall cap as discussed above) and the second lien indebtedness; increases to the interest rate margins; and changes to the maturity. Generally, the market standard for caps on the interest rate margins for both first lien and second lien indebtedness ranges from 2-4% (with some additional increases permitted to second lien interest margins by pay-in-kind amounts). Intercreditor agreements typically provide that the first lien lenders cannot extend their maturity date to a later date beyond the maturity date of the second lien loan without the consent of the second lien lenders; and second lien lenders cannot change their maturity date to an earlier date without the consent of the first lien lenders. Second lien lenders are usually subject to additional restrictions prohibiting, absent the consent of the first lien lenders, amendments to prepayment provisions, to dates upon which payments are due (to earlier dates) and to events of default. Generally, the second lien documentation contains covenants that are slightly "looser" than the covenants contained in the first lien documentation. In addition, the second lien documentation typically contains provisions for an event of default to occur upon a payment default with respect to, or acceleration of the indebtedness under, the first lien credit agreement. The current trend is for the second lien documentation to cross-default to the first lien documentation after a period of time has elapsed (generally 45 days or more).
Another issue is when are the second lien lenders required to release their liens outside of a bankruptcy. As a general rule, the liens of the second lien lenders automatically release on any collateral that is sold in accordance with the provisions of the second lien documentation, although the second lien attaches to the proceeds of any such sale. Apart from asset sales, no collateral can be released unless the second lien lenders consent.
Post Bankruptcy Filing
Once a borrower files for bankruptcy, the Bankruptcy Code provides the context for the debtor-creditor relationship. The typical intercreditor agreement contains many provisions intended to control the relationship between first lien lenders and second lien lenders within this context. For purposes of this article, we will focus on three topics of controversy that may arise during intercreditor negotiations: adequate protection, debtor-in-possession (or DIP) financing and voting rights with respect to a plan of reorganization.
Among the many rights that a secured lender has in bankruptcy is the right to be adequately protected against a decrease in the value of its interest in the collateral. This adequate protection may take the form of periodic cash payments, additional or replacement liens or other relief. Intercreditor agreements often contain restrictions on the ability of second lien lenders to seek adequate protection. Frequently, second lien lenders waive the right to seek adequate protection, but preserve the right to obtain a second lien on any new collateral provided to the first lien lenders as adequate protection. Alternatively, the second lien lenders may preserve their right to seek adequate protection, but consent in advance to the grant to the first lien lenders of a first priority lien on any new collateral provided to the second lien lenders. Second lien lenders generally waive the right to oppose adequate protection for the first lien lenders.
Virtually all bankrupt companies require DIP financing to sustain their operations during the course of the bankruptcy case, and a DIP loan will invariably be secured. The priority and amount of the DIP loan will thus be important to the debtor's pre-bankruptcy secured lenders. Second lien lenders typically agree to some form of advance consent to DIP financings, but there are many variations on this advance consent. Two common variations are advance consent to any DIP financing approved by the first lien lenders, (1) subject to a dollar cap, or (2) only if the liens securing the DIP financing rank prior or equal to the liens securing the first lien debt (i.e. the first lien lender must "share the pain"). Some intercreditor agreements provide for a combination of a dollar cap on DIP financing and a requirement that the first lien lenders share the pain. Whether second lien lenders retain the right to propose their own DIP facility is often negotiated. The right to propose a competing DIP loan may provide the second lien lenders with additional leverage in DIP negotiations, in part, because approval of a financing priming of or pari passu with an existing lien requires the debtor to demonstrate that there is no DIP facility available on less onerous terms than the facility that it has chosen.
As noted above, second lien lenders typically retain rights they would have had as unsecured creditors. In the past, and on occasion currently, second lien lenders are asked to agree in advance to (a) neither support nor vote in favor of a plan of reorganization the first lien lenders oppose or (b) not oppose a plan the first lien lenders support. The right to vote on a plan of reorganization provides a creditor, particularly a secured creditor, with substantial leverage in plan negotiations. The current market consensus is that second lien lenders will not waive in advance their rights to vote on a plan of reorganization.
Conclusion
It appears second lien financings will be around for years to come. Although a market consensus has developed with respect to many intercreditor issues, there remain a number of open points. Moreover, the dynamics of a given deal may have a significant impact on how various intercreditor issues are resolved. For example, in a transaction with a very large second lien loan and a smaller first lien loan, the second lien holders may have greater negotiating leverage. There is not an abundance of case law on the bankruptcy and other courts' willingness to enforce intercreditor provisions. It should be very interesting to see how intercreditor issues are resolved in the next round of bankruptcies.
| Nicholas Whitney |
| Alan Leavitt |
This weeks Learning Curve was written by Nicholas Whitneyand Alan Leavitt, associates of Latham & Watkinsin the firm's finance department.
