The growth of the second lien financing market over the last few years has been nothing short of astounding. Borrowers are attracted to second lien money because of the favorable interest rates, much lower than they would be for traditional mezzanine or high-yield alternatives. In addition, borrowers are also attracted to the second lien market because seldom are they required to deliver equity, either in the form of stock or warrants, to the second lien lenders. Second lien lenders find the market attractive because they pick up security for the loan, security that places them ahead of unsecured trade creditors. First lien lenders have historically been reluctant to permit junior lien financing, but that attitude seems to have been abandoned as first lien lenders opt for higher risk in exchange for better returns.
Second lien financing means that first and second lien holders are granted a security interest in the same collateral, generally all or substantially all assets of the borrower. While each lender's relationship with the borrower is documented in a credit agreement, the key document establishing the relationship between the first and second lien lender is the intercreditor agreement. Care in negotiating the intercreditor agreement is essential. The goals of the first and second lien lenders differ significantly, presenting the opportunity for an interesting, and sometimes contentious, negotiation.
Silence and Cooperation During a Workout
From the perspective of first lien lenders, the intercreditor agreement should make the second lien lenders as silent as possible after a default has occurred. They need assurance that they are first on all collateral and that the proceeds of collateral will be paid over to them until they have been paid in full. They need time after a default to work things out with the borrower and during that period want no interference from the second lien lenders.
In contrast, the second lien lenders need the ability to protect their second lien position from being jeopardized by actions the first lien lenders might take. If the first lien lenders get new collateral, the second lien lenders will want a subordinate lien on those assets, as well. While they may be willing to accept a limitation on their ability to act after default while the first lien lenders are trying to work things out with the borrower, their willingness to be silent will have limitations. After all, second lien lenders do not want the workout to be at their expense.
In most intercreditor agreements today, there is an agreement that second lien lenders will "stand still" after an event of default for some period of time. During the standstill period, the second lien lenders are restricted from exercising remedies against the borrower or against collateral. This gives the first lien lenders time to work things out. While the length of the standstill period is always the subject of negotiation, 180 days is standard, with some a bit shorter and the period sometimes extended if certain measures of progress are being made. The shorter the time period, the more opportunity the second lien lenders will have to interject themselves into the workout negotiations.
Since workouts often result in a consensual sale of assets, the first lien lenders need assurance that the second lien lenders will release their liens on the collateral. Outside of a bankruptcy or foreclosure proceeding, assets cannot be sold without the consent of all parties who have liens on the assets.
Bankruptcy Provisions
Some of the most contentious intercreditor negotiations concern the bankruptcy provisions which deal with the panoply of rights granted to secured creditors in a bankruptcy proceeding. Valuation is a key determinative in a bankruptcy proceeding, as it determines whether a lien creditor has secured creditors' right under the bankruptcy code. Accordingly, whether the second lien loan is "over-secured" or "under-secured" could be critical to the recoveries of the second lien lenders. Yet, at the time the loans are documented, it is seldom possible to know with certainty how a valuation at the time of a possible bankruptcy will turn out. The negotiated provisions in intercreditor agreements, therefore, can result in real value landing in the pockets of one lien creditor or another upon a bankruptcy filing.
DIP Financing
The first place adequate protection rights are likely to arise is in the context of debtor-in-possession financing, or "DIP financing." Businesses in Chapter 11 cases need to maintain operations during the proceeding.
DIP financing is often provided to a Chapter 11 debtor by the same lenders who provided senior debt financing prior to the bankruptcy. The DIP lender will want to ensure that the borrower can maintain its going-concern value until a reorganization or sale of the business can be realized. The DIP facility will likely be secured by a senior or "priming" lien on all assets, the bankruptcy law will require that other lien holders be given consent rights, or alternatively "adequate protection," discussed in more detail below. As a result, the first lien lender's DIP financing arrangement could be thwarted without the second lien lenders' cooperation and consent. Accordingly, most intercreditor agreements include consent to any DIP financing provided or consented to by the first lien lender.
Adequate Protection and Use of Cash Collateral
Bankruptcy rights for secured creditors include the right to be adequately protected if the debtor uses collateral, including cash, during the bankruptcy case. To the extent the collateral diminishes in value during the case, a secured creditor has a right to be protected from any decline in value. Adequate protection usually takes the form of replacement liens and cash payments. If adequate protection cannot be provided, then the secured creditor can get relief from the automatic stay and proceed to foreclose on the collateral. If this right has not been waived in advance, or curtailed significantly, the first lien lenders' rights to control the proceeding will be significantly impaired.
Sales of Collateral
The same holds true for the sale of collateral during the Chapter 11 case. As in the pre-bankruptcy time period, the first lien lender wants the cooperation of the second lien holder in permitting the sale of assets to take place. In contrast to the workout phase, cooperation in the form of an agreement to release liens is not imperative because the bankruptcy judge has the power to order that property be sold free and clear of liens without the second lien lender's consent. The focus, however, is getting the second lien lender to agree in advance not to raise an objection to any sale that has the support of the first lien lender.
Plans of Reorganization and Voting
Probably the most contentious negotiation is over the vote that a second lien holder will have on any plan of reorganization proposed in the bankruptcy case. Bankruptcy plans are required to classify creditor claims. Generally, each secured creditor is placed in its own class. In addition to its own class for its secured claim, to the extent the secured creditor is under secured, its deficiency claim becomes part of the general unsecured class. Since bankruptcy plans generally must be accepted by each class of impaired creditors, especially those that are more senior in priority of payment, ensuring the second lien lenders' vote on the plan can greatly enhance the ability of the first lien lenders to effectuate a plan of their liking. It also greatly reduces the likelihood that the second lien lenders might present their own plan seeking to "cram-down" the first lien lenders. Conversely, giving up their right to vote can work to the disadvantage the second lien lenders.
Most astounding about the negotiation of this issue is the absolute lack of certainty as to whether the assignment of voting rights from a second lien lender to a first lien lender will be enforced in a bankruptcy case. With the growth of second lien financings a recent development, there is little case law to guide us. The few cases that have been published are inconsistent. In one case in Chicago, the bankruptcy court refused to take the vote away from the second lien lender and give it to the first lien lender even though the intercreditor agreement clearly provided for such a result. In the view of the court, pre-bankruptcy contracts cannot waive rights granted by the Bankruptcy Code. The Chicago bankruptcy court found that, while the Bankruptcy Code endorses subordination agreements, a subordination agreement deals only with the relative priority of claims and not the waiver or assignment of various bankruptcy rights. In contrast, a bankruptcy court in Philadelphia found no reason to dishonor the assignment of a second lien lender's right to vote on a plan to the first lien holder.
Option to Purchase First Lien Loan
One approach used by second lien lenders to eliminate the impact of provisions intended to silence them or limit their rights is the right to buy out the first lien lenders at par plus accrued interest. If a lender does not like the actions contemplated by the first lien lender, either prior to or during a bankruptcy proceeding, it can simply acquire the first lien position.
Identity of Players in the Syndicated Markets
There are other practical considerations that need to be considered by borrowers and first lien lenders when inviting second lien lenders into credit arrangements. Along with the growth of the second lien financing market, there has been an increase in the number of players investing in these loans and in the ease by which first and second lien loans are transferred. There is no assurance that the identity of second lien lenders will be the same at loan inception as they are at the time of a default or bankruptcy. Historically, the first lien lenders were willing to allow second liens to be placed on collateral when they had comfort as to the identity and investment style of the second lien lender. But, in today's marketplace, any control over the identity of the second lien lenders has been lost.
Another factor may be the number of lenders in the second lien syndicate. If the number is large, it can complicate negotiations during a workout or a bankruptcy. The "herding cats" analogy has some relevance here. A recent negotiation involved a second lien financing with over 60 participants in the syndicate. Obtaining a consensus amongst such a large group cannot help but complicate matters.
The transfer of loans from one lender to another presents another interesting issue. Lenders today often acquire pieces of both the first and second lien debt. The motivations of the parties at the table can change dramatically depending on how much of each loan they hold. No longer does the lender concern itself with what it will receive on the first or second lien to the exclusion of the other. Rather, it considers the recovery on the combined holdings.
This learning curve was written by By Mark Berman, Esq. and Amanda Darwin, Esq. Nixon Peabody LLP