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Presenting a live 90-minute webinar with interactive Q&A

Enforceability of Intercreditor Agreements

in Bankruptcy: Maximizing Recovery for

First and Second Lienholders

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, AUGUST 2, 2017

Eric W. Anderson, Partner, Parker Hudson Rainer & Dobbs, Atlanta

C. Edward Dobbs, Partner, Parker Hudson Rainer & Dobbs, Atlanta

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Enforceability of Intercreditor Agreements in Bankruptcy:

Maximizing Recovery for First and Second Lienholders

By

Eric W. Anderson

August 2, 2017

Parker Hudson Rainer & Dobbs LLP 303 Peachtree St NE; Suite 3600

Atlanta, Georgia 30308 404.420.4331

© 2017 Eric W. Anderson

Acknowledgement The author wishes to note that these materials are based largely on the excellent materials prepared by Mark N. Berman (retired from Nixon Peabody, and now Adjunct Professor at Northeastern University) for a previous version of this webinar, and which have been updated and revised by the author. Mr. Berman has graciously allowed me to use his materials as the basis for this presentation, for which I extend my thanks.

6

Applicable Statute

• Section 510(a) of the Bankruptcy Code:

A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.

7

• Section 510(a) of the Bankruptcy Code: • What is a subordination agreement?

• To what extent is a subordination agreement enforceable outside of bankruptcy?

• UCC § 1-302 "Variation by Agreement" • UCC § 9-339 • Official Comment to UCC § 9-602: reflects caution of

courts: • "The suspicious attitudes of the courts have been grounded in

common sense. This section, like former Section 9-501(3), codifies this long-standing and deeply rooted attitude. The specified rights of the debtor and the duties of the secured

party may not be waived or varied except as stated."

Applicable Statute (cont.)

8

– In the context of a Second Lien Financing: • Secured creditors have an interest in the debtor’s property and, therefore, the right to have that interest protected.

• Secured creditors are usually entitled to be classified separately from other secured and all unsecured creditors.

Effects of Subordination Agreements

9

– In the context of Mezzanine Financing: Mezzanine debt is generally not secured by assets of the debtor, and accordingly the mezzanine lender has no interest in the debtor's assets that would require adequate protection.

– The mezzanine lender generally lends to the holder of equity with a pledge of that equity to secure the loan.

-- However, some mezzanine deals may be structured as a subordinate loan to the borrower rather than to the equity holder, and may include a subordinate lien on a borrower’s assets; senior lender must be alert to this.

Effects of Subordination Agreements

10

Evolution of Case Law on Enforcement of Subordination

Agreements

Early cases limit agreements' effects to those affecting "distribution of assets" or payment terms, but not additional rights, such as bankruptcy waivers

– Hart Ski (1980) – 203 North LaSalle Street Partnership (2000)

11

Later case law development shows movement towards enforcement of bankruptcy waiver provisions and other non-payment or lien subordination provisions

– Aerosol Packaging (2006) – Ion Media (2009) – Erickson Retirement Communities (2010)

Evolution of Case Law

12

– Examples of sorts of provisions:

– Adequate Protection for Use of Cash Collateral

– Providing DIP Financing

– Appointment of an Examiner

– Bidding Procedures for Sales of Assets

– Sales of Assets

– Plan Voting Rights

– Objections for Confirmation of a Plan

– Cram Down of a Secured Creditor Under a Plan

Evolution of Case Law

13

Trend has continued in recent years, and in particular courts have shown willingness to enforce robust bankruptcy waiver and related provisions when parties are sophisticated

– e.g., Caesars Entertainment Operating (2016) – Ion Media Networks (2009)

Evolution of Case Law

14

– Beatrice Foods Co. v. Hart Ski Mfg. Co., Inc. (In re Hart Ski Mfg. Co., Inc.), 5 B.R. 734 (Bankr. D. Minn. 1980):

• What was case about? • The subordination agreement entered into by Beatrice and Aetna prior to the bankruptcy case provided:

“Creditor (Beatrice) will not, without your (Aetna’s) written consent, assert, collect or release the indebtedness or any part thereof or realize any collateral securing the indebtedness or enforce any security agreements, real estate mortgages, lien instruments, or other encumbrances securing said indebtedness except that it may collect regularly scheduled payments when and as due as provided above.”

Adequate Protection

15

– Bankruptcy Court holding:

• “The intent of §510(a)(Subordination) is to allow the consensual and contractual priority of payment to be maintained between creditors among themselves in a bankruptcy proceedings. There is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets.” Hart Ski, at 736 (emphasis added).

Adequate Protection (cont.)

16

– The Bankruptcy Court cited various non-payment-type terms that the Bankruptcy Code provides to secured creditors, including:

• the right to assert and prove its claim,

• the right to seek court-ordered protection for its security,

• the right to have a stay lifted under proper circumstances,

• the right to participate in the voting for confirmation or rejection of any plan of reorganization,

• the right to object to confirmation, and

• the right to file a plan where applicable.

Adequate Protection (cont.)

17

The Bankruptcy Court went further to note that the senior creditor would be protected due to other subordination provisions:

• “No prejudice can be shown by Aetna if Beatrice is allowed to assert its claim. Any money collected by Beatrice must be held in trust by Beatrice and paid to Aetna until Aetna is paid in full.”

Adequate Protection (cont.)

18

However, more recently, in Aurelius Capital Master v. Tousa, 2009 WL 6453077 (S. D. Fla. Feb. 6, 2009), court upheld adequate protection waiver provisions (and waiver of right to object to cash collateral use) from intercreditor agreement:

• Court ruled that junior creditor did not have standing to object to cash collateral use because of waiver in ICA. Id. at *8. • "Put differently, [junior creditor] had bargained away its right to object by entering into the Intercreditor Agreement." Id.

Adequate Protection (cont.)

19

In re Caesars Entertainment Operating Co., Inc., 562 B.R. 168 (Bankr. N.D. Ill. 2016). Recognition that sophisticated parties should be held to higher standard.

"True, debtors have been held protected against prepetition waivers of the benefits of bankruptcy. But debtors are one thing, creditors another. There is no similar protection for creditors – particularly not large, sophisticated creditors represented by large, sophisticated law firms." Id. at 179-180 (citations omitted)

Waivers may be enforceable against sophisticated creditors

20

In re MPM Silicones, LLC (“Momentive”) (Case No. 14- 22503-rdd, Adv. Proc. Nos. 14-08248 [Docket No. 50], 14-08247 [Docket No. 60] (Bench Rulings).

• 1st lien lenders sued the 2nd lien lenders for alleged violations of the intercreditor agreement and sought to enjoin future violations.

– Supporting DIP Financing with priority over 1st lien – Opposing 1st lien request for adequate protection; – Intervening in an adversary proceeding contesting 1st lien lenders’ rights to make-whole premium, i.e. contesting 1st lien lenders’ claims; – Supporting a cramdown plan of reorganization. – Retaining common collateral when 1st lien wasn’t paid in full.

DIP Financing

21

• The Intercreditor Agreement provided:

“Rights as Unsecured Creditors: Notwithstanding anything to the contrary in this Agreement, the Second-Priority Agents and the Second-Priority secured Parties may exercise rights and remedies as an unsecured creditor …” .

• Court rules against 1st lien lenders – citing Boston Generating (see, p. 40, infra.) for the proposition that “…waivers of a secured creditor’s rights under [subordination] agreements must be clear beyond peradventure.”

DIP Financing (cont.)

22

Bank of America, NA v. North LaSalle Street Limited Partnership (In re 203 North LaSalle Street Partnership), 246 B. R. 325 (Bankr. N. D. IL 2000):

– The debt subordination agreement provisions:

• “North LaSalle covenants and agrees that the North LaSalle Loan and the North LaSalle Loan Documents, as they may be, at any time from time to time, amended, modified, supplemented, substituted, replaced or restated, are and shall at all times be and remain junior and subordinate to the [Senior Bank] Transactions…” • “[North LaSalle] further agrees that in the event of any … reorganization ... (c) [North LaSalle] hereby irrevocably agrees that the Bank may, at its sole discretion, in the name of [North LaSalle] or otherwise … file, prove, and vote or consent in any such proceedings with respect to, any and all claims of [North LaSalle] relating to the Junior Liabilities.”

Plan Voting Rights

23

– BofA, as the senior secured lender, filed a complaint seeking a declaratory judgment as to the effect of subordination agreements entered into between BofA and North LaSalle Street Limited Partnership, which was both the general partner of the debtor and a subordinated secured lender. – Issue was whether the North LaSalle could vote its subordinated claim or whether BofA, as the senior secured creditor, could vote BofA’s claim as provided in the subordination agreements.

Plan Voting Rights (cont.)

24

– Court's holdings:

“While the language of the subordination agreements governs the outcome of the Bank’s right to repayment of any deficiency claim, the language of the Bankruptcy Code governs the determination of voting rights in this case. Section 1126(a) of the Code provides that “the holder of a claim” may vote to accept or reject a plan under Chapter 11……North LaSalle is the holder of the claim….North LaSalle should therefore be allowed to vote its claim in the confirmation process.” Id. at 330-331(emphasis added)

Plan Voting Rights (cont.)

25

– The Court also held that pre-bankruptcy agreements generally do not override contrary provisions of the Code :

“§510(a), in directing enforcement of subordination agreements, does not allow for waiver of voting rights under §1126(a) . . . Subordination thus affects the order of priority of payment of claims in bankruptcy, but not the transfer of voting rights.” Id. at 331.

Plan Voting Rights (cont.)

26

– Judge Wedoff follows the reasoning of Hart Ski.

“Although a creditor’s claim is subordinated, it may well have a substantial interest in the manner in which its claim is treated. Subordination affects only the priority of payment, not the right to payment. If assets in a given estate are sufficient, a subordinated claim certainly has the potential for receiving a distribution, and Congress may well have determined to protect that potential by allowing the subordinated claim to be voted.” Id. at 332(emphasis added).

Plan Voting Rights (cont.)

27

– Other cases agreeing with 203 N. LaSalle:

• In re Croatan Surf Club, LLC, 2011 WL 5909199 (Bankr. E.D. N.C. Oct. 25, 2011)

“[Senior creditor] is “empowered…to file claims and proofs of claims and take such other action (including, without limitation, voting the Subordinate Debt…) as it may deem necessary or advisable for the exercise, enforcement or preservation of any rights or interests of [senior creditor] hereunder.”

Plan Voting Rights (cont.)

28

• In re: SW Boston Hotel Venture, LLC et al., 2011 WL 5520928 (Bankr. D. Mass. Nov. 14, 2011) [later reversed on other grounds];

• Intercreditor agreement provided: “In the event of …a bankruptcy … reorganization … whether or not pursuant to bankruptcy laws … Junior Lender will assign to Senior Lender the voting rights of Junior Lender in such proceeding…”

• “To the extent a provision in a subordination agreement purports to alter substantive rights under the Bankruptcy Code, it is invalid. This Court follows and adopts the reasoning of Judge Wedoff in [203 N. LaSalle]…” (emphasis added)

Plan Voting Rights (cont.)

29

Blue Ridge Investors, II, LP v. Wachovia Bank, N.A. and Aerosol Packaging, LLC (In re Aerosol Packaging, LLC), 362 B.R. 43 (Bankr. N.D. Ga. 2006)

Case involving plan voting rights:

• Junior creditor entered into a subordination agreement with senior creditor at inception of loan. Subordination agreement modified twice pre-petition. • Debtor is a party to the subordination agreement and entitled to rely on its enforcement.

30

The Tide Begins to Turn: Plan Voting Rights

• Provisions in subordination agreement authorized senior creditor to vote the junior creditor’s claim, and to receive any distribution allocated to the junior creditor.

“Lender is hereby irrevocably authorized and empowered (in its own name or in the name of the Subordinated Creditor or otherwise), but shall have no obligation, to demand, sue for, collect and receive every payment or distribution referred to in subsection (a) above and give acquittance therefore and to file claims and proofs of claim and take such other action (including without limitation voting the Subordinated Debt or enforcing any security interest or other lien securing payment of the Subordinated Debt) as it may deem necessary or advisable for the exercise or enforcement of any of the rights of the Lender hereunder…”

31

Aerosol Packaging Case

• Court finds that junior creditor “has provided no evidence, argument or authority that the Subordination Agreement is not enforceable under applicable nonbankruptcy law.” • Without analysis or citation, court says that “[t]he Subordination Agreement appears to be enforceable under Georgia law, which is the applicable nonbankruptcy law.”

• Junior creditor apparently had the right to purchase the senior lender’s claim. The court felt this afforded the junior creditor a remedy.

32

Aerosol Packaging

Other cases that stand for the same proposition as Aerosol:

– In re Coastal Broadcasting Systems, Inc., 2012 Bankr. LEXIS 3098 (Bankr. D. NJ July 6, 2012)(unpublished); Affirmed, 570 Fed. App'x. 188 (3d Cir. 2014).

– In re Curtis Center Limited Partnership, 192 B.R. 648, 659-660 (Bankr. E.D. Pa. 1996) – In re Inter Urban Broadcasting of Cincinnati, Inc., 1994 WL 646176, at *2 (E.D. La. 1994) – Broadcast Capital, Inc. v. Davis Broadcasting, Inc., (In re Davis Broadcasting, Inc.), 169 B.R. 229 (Bankr. M. D. Ga. 1994), rev’d on other grounds, 176 B.R. 290 (M.D. Ga. 1994) – Matter of Itemlab, Inc., 197 F. Supp. 194 (E.D.N.Y. 1961) [decided under the Bankruptcy Act]

33

Plan Voting Rights (Cont.)

Ion Media Networks, Inc., et al., 419 B.R. 585 (Bankr. S.D.N.Y. 2009)

• Intercreditor Agreement included silent second lien provisions:

– No Contest Clause: “[U]pon the commencement of a case under the Bankruptcy Code by or against any Grantor, … each secured party agrees not to take any action or vote in any way inconsistent with this Agreement so as to contest (1) the validity or enforcement of any of the Security Documents…(2) the validity, priority, or enforceability of the Liens, mortgages, assignments, and security interests granted pursuant to the Security Documents…(3) the relative rights and duties of the holders of the First Priority Obligations”

34

Objections to Confirmation of a Plan

– Ion Media Networks The intercreditor agreement also contained the following clauses:

– Support for Plan Clause: Unless the First Lien Lenders are paid in full, the Second Lien Lenders may not “oppose, object to or vote against any plan of reorganization or disclosure statement the terms of which are consistent with the rights of the First Priority Secured Parties under the Security Agreement.”

35

Objections to Confirmation of a Plan

– Rights as an Unsecured Creditor Clause: Provision in the intercreditor agreement allowed second lien Lenders to exercise rights of an unsecured creditor, but there was an exclusion for actions that were otherwise prohibited in certain sections of the agreement. The proscribed activities included: (i) objecting to the plan, (ii) objecting to the DIP Loan Facility, and (iii) objecting to the disclosure statement, all consistent with other clauses in the intercreditor agreement.

36

Ion Media (cont.)

– Bankruptcy Court distinguishes 203 N. LaSalle and Aerosol Packaging cases because they involved the right to vote on a plan.

– “plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and creditor expectations should be appropriately fulfilled”

37

Ion Media (cont.)

Noteworthy issues in opinion:

• Is this an invitation to litigation by senior lender against subordinate lender?

• Court was clearly influenced by what it saw as the subordinated creditor's use of “obstructionist” tactics to put barriers in the way of plan confirmation despite agreements not to do so. • Court also influenced by the fact that junior creditor was "sophisticated, economically motivated and woefully out of the money. . ."

38

Ion Media (cont.)

Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D. Tex. 2010).

• The subordinated creditors had agreed not to “exercise any

rights or remedies or take any action or proceeding to collect or enforce any of the Subordinated Obligations” without “the prior written consent of the Agent” until the senior secured lenders had been “fully satisfied.”

• Bankruptcy Court finds that subordination agreement

provisions prohibited the subordinated creditors from seeking appointment of an examiner.

39

Appointment of an Examiner

• Senior lender agent opposed motion seeking to appoint an examiner.

• However, the language in the Subordination Agreement did not

specifically define an enforcement action to include seeking the appointment of an examiner.

• Follows the reasoning of Ion Media in finding that “[t]his is the

very type of obstructionist behavior that the agreement are intended to suppress.” Id. at 315.

40

Appointment of an Examiner (cont.)

In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010).

– The intercreditor agreement included the following provisions concerning release of liens in collateral:

• “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 . . . 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 [junior lender]…” (emphasis added)

41

Sales of Assets

And this provision limiting junior lender's rights:

• “Without Limiting the generality of the foregoing, unless and until the Discharge of First Lien Obligations has occurred, except as expressly provided in [other provisions of the agreement], the sole right of the [junior lender] 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.”

42

Sales of Assets (cont.)

– Drafting precision is needed. – "If a secured lender seeks to waive its rights to object to a 363 sale, it must be clear beyond peradventure that it has done so." Id. at 319. – Cites to ABA model intercreditor agreement for good language. – Court finds that subordinated creditor had standing to object.

43

Sales of Assets (cont.)

– Sale of Assets Provision (examined in Boston Generating):

“Second Lien Agent, as holder of a Lien on the Collateral and on behalf of the Second Lien Claimholders, will not contest, protest, or object, and will be deemed to have consented pursuant to section 363(f) of the Bankruptcy Code, to a Disposition of Collateral free and clear of its Liens or other interests under section 363 of the Bankruptcy Code if First Lien Agent consents in writing to the Disposition provided that …(i) the liens of the second lien creditors attach to the proceeds of such disposition to the extent so ordered by the court, (ii) the net cash proceeds are applied to reduce the first lien obligations permanently, and (iii) the second lien creditors will not be deemed to have waived any right to bid in connection with such disposition.”

44

ABA Model Intercreditor Agreement

– From the Model Intercreditor Agreement Task Force Mission Statement: "The Model First Lien/Second Lien Intercreditor Agreement Task Force was established by the ABA to develop a balanced, market- based model form of intercreditor agreement that specifies the rights of first lien and second lien lenders holding pari passu senior debt secured by identical collateral that fairly protects the respective interests of first lien and second lien lenders while reflecting market expectations and standard practices."

– The Task Force Report along with the Model Agreement was published in the May 2010 edition of The Business Lawyer.

• A copy of the Task Force Report and of the Model Agreement is available on the Task Force website

– http://www.abanet.org/dch/committee.cfm?com=CL190029

45

ABA Model Intercreditor Agreement (cont.)

TCI Holdings 2, LLC, 428 B.R. 117 (Bankr. D. N. J. 2010) – Points out that Section 1129(b)(1) of the Bankruptcy Code limits Section 510(a) of the Bankruptcy Code in the context of confirming a plan over the objection of a secured creditor via cram down.

• Statute: In Section 1129(b) – the cramdown provisions – introductory phrase says: "Notwithstanding section 510(a) of this title . . . "

• First lien lenders objected to confirmation of a cram down plan proposed by second lien lenders

• Court overruled first lien lenders’ objection finding that the Intercreditor Agreement provisions restricting distributions to subordinate creditors were not enforceable when confirmation of a plan takes place by cram down under Section 1129(b)(2).

46

Cram down – a loophole in Section 1129(b)?

– Bank of America NA v. PSW NYC LLC, 29 Misc.3d 1216(A), 2010 WL 4243437 (NY Sup. Ct. Sept 16, 2010) (unreported)

• Court enforces intercreditor agreement. Mezzanine lender was prohibited from foreclosing on a pledge of the equity in the borrower until senior lender was paid in full.

– Highland Park CDO I Grantor Trust v. Wells Fargo Bank, N.A., 2009 WL 1834596 (S.D.N.Y. June 16, 2009)

• Court enforces intercreditor agreement that prohibited subordinated mezzanine lender from recovering against borrower or guarantor until senior lender was paid in full. • Agreement prohibited subordinated lender from receiving "any payment on account of the Mezzanine Loan." Court read that to extend to any payment from guarantor, not only borrower.

47

Real Estate Loans Secured By Equity Pledge

– Understand which provisions of the intercreditor agreement affect priority and which do not

• Advise client that non-priority provisions, especially voting provisions, may not be enforceable. (Hart Ski, 203 N. LaSalle, Croatan Surf Club; but see Aerosol Packaging)

– Important work is in drafting stage, upfront, NOT when borrower enters bankruptcy. – Ambiguity will almost always be construed against the party seeking to restrict rights, which means, in most cases, against the senior lender.

48

Lessons and Practice Pointers

– First lien lenders might want to consider including those provisions that influenced the Aerosol and Ion Media courts to enforce the intercreditor agreement:

– Second lien lender buy-out of first lien lender position

– Make the Debtor a party to the intercreditor agreement

49

Lessons and Practice Pointers

– Be as specific as possible in identifying prohibited activities. – Objecting subordinated lenders need to avoid being seen as “obstructionist.” (Ion Media and Boston Generating) – It will help if subordinated lenders can show they are either in the money or close to being there. (Boston Generating)

50

Lessons and Practice Pointers

Thank you!

Questions? Eric W. Anderson Parker Hudson Rainer & Dobbs LLP 404.420.4331 eanderson@phrd.com

5000631.1

51

INTERCREDITOR AGREEMENTS – DRAFTING

CONSIDERATIONS WITH BANKRUPTCY IN MIND

By C. Edward Dobbs

Parker, Hudson, Rainer & Dobbs LLP

303 Peachtree Street, N.E.

Suite 3600

Atlanta, Georgia 30308

(404) 420-5529

edobbs@phrd.com © 2017 C. Edward Dobbs

INTRODUCTION

This presentation assumes that:

(a) the Intercreditor Agreement ("IA") is between a first lien lender ("1st Lien")

and a second lien lender ("2d Lien"), both having liens on the same

collateral with each obligor granting a lien (a "Grantor") also a party to the IA

(b) the IA provides only for a lien (and not a debt) subordination;

(c) 1st Lien is a working capital lender and 2d Lien is a term lender or indenture

trustee;

(d) 1st Lien and 2d Lien debt and liens are separately documented, with

separate lien grants; and

53

(e) all of the IA provisions are enforceable in a bankruptcy ("BK") case

of each Grantor

Outcome of the negotiations will depend, in part, upon a variety of

factors, including relative size of the 1st Lien and 2d Lien debt, the

willingness of either to replace the other in the borrower's capital

structure if IA negotiations break down, and the past experiences of the

parties with one another

54

GENERAL BANKRUPTCY PROVISIONS

1. No Challenge to Liens

Both 1st Lien and 2d Lien agree not to challenge each other's liens

Note: When each party has its own priority in a so-called "split-collateral"

deal, each may wish to reserve right to challenge whether certain

collateral falls into the other’s priority category

2. Adequate Protection

(a) 2d Lien will forbear from opposing adequate protection sought by 1st

Lien

(b) 2d Lien's parameters of adequate protection are pre-negotiated and often

limited to subordinate adequate protection liens and occasionally payment

of post-petition interest and attorneys' fees

55

(c) 2d Lien’s §507(b) claim subordinate to 1st Lien’s §507(b) claims

3. Stay Relief

(a) 2d Lien will not seek stay relief unless sought by 1st Lien

(b) 2d Lien will not oppose stay relief sought by 1st Lien

4. Avoidance and Reinstatement

(a) If a payment to 1st Lien or 2d Lien is avoided, the debt intended to be paid

is reinstated, and

(b) If IA has been terminated, IA is also reinstated

5. Rights of Unsecured Creditor

(a) 2d Lien may argue it should have all rights in a BK case to take actions

and make objections that an unsecured creditor could take or make

56

(b) 1st Lien may resist a general reservation as overly broad and in conflict

with other IA provisions, but may agree to 2d Lien's exercise of unsecured

creditor rights in specific areas, such as objections to terms of 363 sale or

bid procedures or economic terms of DIP financing provided by 1st Lien

(c) If general reservation is consented to, IA should exclude specific areas

where 2d Lien is prohibited from taking action as a secured creditor (e.g.,

challenging 1st Lien's perfection or priority or opposing 1st Lien's stay relief

or adequate protection requests)

6. Allocation of Split-Collateral Proceeds

(a) Consequences of silence in IA

(b) Allocation options and considerations

57

CONDITIONAL AND ABSOLUTE

SUBORDINATIONS

1. Issue: What is the result in BK if 1st Lien is avoided or equitably

subordinated?

E.g. – 1st Lien owed $500K

– 2d Lien owed $1 mil.

– Collateral = $1 mil.

2. If IA Silent

– 1st Lien avoided and preserved under §551 for benefit of estate, with result

that estate receives $500K from collateral

– 2d Lien gets $500K ($1 mil. collateral minus preserved 1st Lien)

Note: 2d Lien not hurt, but receives no windfall

58

3. Conditional Subordination

(a) If subordination by 2d Lien is conditioned upon 1st Lien not being avoided

or equitably subordinated, 2d Lien argues subordination is ineffective if

those events occur, 2d Lien assumes first priority position (receiving $1

mil. in collateral proceeds) and BK trustee takes nothing from collateral

(b) 2d Lien might have problems if 1st Lien was a "natural first" ( i.e., perfected

first), as BK trustee may argue contractual subordination was superfluous,

conditional subordination not relevant, and avoidance and preservation

of 1st Lien under §551 is unaffected by IA

Note: 2d Lien may press for language in IA that priorities are

automatically reversed at any time 1st Lien is unperfected or if 1st

Lien is avoided or equitably subordinated

59

4. Absolute Subordination

(a) If IA provides 2d Lien's subordination is absolute, irrespective of

avoidance or equitable subordination of 1st Lien, 2d Lien may suffer

E.g. – BK trustee avoids 1st Lien and gets 1st Lien’s first $500K;

– 2d Lien gets next $500K, but must turn over to 1st Lien

per IA;

– 2d Lien's claim deemed paid, vis-à-vis debtor, by

$500K;

– 2d Lien subrogated to 1st Lien's unsecured claim

(b) If 1st Lien debt is also equitably subordinated, 2d Lien is worse off than if it

had been a general unsecured creditor, as it would be subrogated to an

equitably subordinated 1st Lien claim

5. Effect of Equitable Subordination

(a) If 1st Lien is equitably subordinated only to certain unsecured creditors

harmed by 1st Lien's inequitable conduct, there should be carved out of

60

1st Lien's collateral any losses suffered by those creditors (not to

exceed 1st Lien debt) -- 2d Lien unharmed

(b) If 1st Lien is disallowed as a secured claim due to equitable subordination,

1st Lien is "void" under § 506(d) but is preserved for estate under §551

61

FURTHER SUBORDINATION OF 1ST LIEN

1. Issue: What if 1st Lien contractually subordinates to a third party's lien that is

junior to 2d Lien? What impact on 2d Lien in a liquidation of the

collateral?

2. Examples of Third Party Lienors:

– landlords

– custom brokers

– carriers

– processors

– factors

– equipment vendors/lessors

– sureties on bonded jobs

– inventory or equipment vendors

62

3. Options:

(a) If IA is silent and if:

– 1st Lien = $100K

– 2d Lien = $200K

– 3d Lien = $500K

– Collateral = $700K

A few courts hold:

– 3d Lien (elevated to first position) gets $500K

– 1st Lien gets $100K

– 2d Lien gets $100K (50% of claim)

Note: 2d Lien bears brunt of 1st Lien's subordination

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Better reasoned cases hold:

– 3d Lien gets $100K

(out of 1st Lien's first position)

– 2d Lien gets $200K

(unaffected by 1st Lien's election to subordinate)

– 3d Lien gets $400K

(balance owed to it)

– 1st Lien takes nothing

Note: 1st Lien bears brunt of its subordination

(b) If IA requires 2d Lien also to subordinate to 3d Lien or provides

that 1st Lien remains prior to 2d Lien despite 1st Lien's

subordination to 3d Lien:

– 3d Lien elevated to first position and gets $500K

– 1st Lien gets $100K

– 2d Lien gets $100K (50% of claim)

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4. Grantor's Business Needs

(a) Grantor’s business needs may require periodic lien subordinations to

certain ordinary course liens

(b) 1st and 2d Liens can accommodate such ordinary course liens in

IA, such as:

– "Permitted Liens" under both set of loan documents,

and/or

– Other specified liens that are customary and in ordinary

course of borrower's business and capped individually

and/or in an aggregate amount

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5. Unintentional Subordination by 1st Lien

E.g. – 1st Lien = $500K

– 2d Lien = $500K

– Collateral value = $1 mil.

– Federal tax lien = $100K

– Per IRC 45-day rule, assume tax lien trumps $50K of future

advances by 1st Lien

IRS gets $50K

1st Lien gets $450K ($50K loss)

2d Lien gets $500K (full recovery)

Note: 2d Lien should remain unaffected

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CAPPED 1ST LIEN DEBT

1. Two Approaches:

(a) Dollar cap; and/or

(b) Borrowing base (“BB”) cap

2. Consequences of Exceeding Cap. IA should spell out consequences of

exceeding the cap, including:

(a) If IA contains a covenant by 1st Lien not to exceed cap, 2d Lien may assert

breach of IA and seek to recover damages suffered or to enjoin 1st Lien's

enforcement rights

(b) Waterfall changes –1st Lien debt in excess of cap paid to 1st Lien only after 2d

Lien debt is fully paid; and/or

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(c) 2d Lien's purchase option is triggered

Note: Important to spell out when exceeding the cap is tested and effect of later

reduction of 1st Lien debt to an amount within the cap

Note: 1st Lien may seek to cap amount of 2d Lien debt in waterfall

3.Dollar Cap

(a) Both overall cap and separate subcaps for revolver, term loan and

banking relationship debt

(b) Make provision for line of credit ("LOC") growth (and possibility of

DIP financing)

(c) Take into account any "accordion" feature in LOC

(d) For term loans, cap may reduce by (i) payments actually made

(with no authority to reload) or (ii) payments required to be made

(Note: clause (ii) can be dangerous for 1st Lien)

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(e) Make sure cap is inclusive not only of (i) principal amount of debt (loans

and letters of credit), but also (ii) add-on's (without a cap):

(1) interest (including post-petition accruals)

(2) lender and LC issuer fees

(3) enforcement expenses

(4) indemnities

(5) protective advances

(f) Make provision for banking relationship debt (e.g., cash management,

credit cards, ACH transactions, hedges), which sometimes is the subject of a

subcap

4. Borrowing Base Cap

(a) Revolver (principal only) limited by lesser of (i) the LOC (with a growth

or emergency cushion) or

(ii) a BB cap

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(b) BB cap should allow for some level of overadvances or post-default

"Agent Advances" (e.g., the greater of a percentage of the BB or a

dollar amount)

(c) 1st Lien will want the right to rely upon BB certificates and to be able

to test BB at the time of each credit extension, without regard to future

changes in BB (i.e., no "backed in" overadvance)

Note: 2d Lien may have concerns over Grantor’s post-default

cessation of provision of BB certificates by Grantor or reduced

frequency of reporting

(d) 1st Lien may attempt to exclude from revolver cap any revolver

loans that would otherwise cause cap to be exceeded if loan

proceeds are used to pay 2d Lien debt or add-on's with respect to

1st Lien debt within the cap

5. Combined Cap

(a) Lesser of dollar or BB cap

(b) Greater of dollar or BB cap

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CASH COLLATERAL/DIP FINANCING

1. 2d Lien's Consent to Use of Cash Collateral

(a) 2d Lien will consent to the extent 1st Lien consents, provided

(b) 2d Lien is granted a replacement lien, as adequate protection, on post-

petition assets, but junior in priority to pre-petition and post-petition

liens in favor of 1st Lien ("2d Adequate Protection Liens")

2. 2d Lien's Consent to DIP Financing

(a) 2d Lien won't oppose, will be deemed to have consented to (and at a

hearing will consent to) any priming DIP financing consented to or provided

by 1st Lien, subject to 2d Lien being provided 2d Adequate Protection

Liens

(b) 2d Lien may seek to condition consent upon aggregate of pre-petition

1st Lien debt and DIP financing not exceeding any dollar or BB cap in

IA

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(c) 2d Lien may seek to reserve objection rights to economic terms of DIP

financing that are not "market" or otherwise reasonable (e.g., interest

rate, fees, lending limits, term of commitment)

(d) 2d Lien may seek to reserve objection rights to "case management provisions" in DIP financing (e.g., required 363 sale, plan provisions

and milestones)

3. Some Hotly Negotiated Topics

(a) 2d Lien's right to request adequate protection payments (e.g., post-petition

interest and/or periodic principal payments, and reimbursement for post-

petition professional expenses, such as expenses of attorneys,

accountants and other consultants)

(b) 2d Lien's reservation of right to object to DIP financing on any basis that an

unsecured creditor could object

(c) Priming DIP financing must also prime 1st Lien's pre-petition liens

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Note: If 1st Lien provides DIP financing, this may impede 1st Lien's

ability to "roll over" 1st Lien debt over time from collections of

pre-petition collateral or "roll up" 1st Lien debt into DIP financing

on day one

(d) 2d Lien's subordination to professional expense "carve-out" in DIP financing

order to the extent consented to by 1st Lien

— 2d Lien may insist that 1st Lien reserve carve-out against BB

— 1st Lien may insist upon an allocation of the carve-out in a split-

collateral deal (whether based on the ratable amount of their

outstanding loans or relative value of their respective priority

collateral)

(e) 2d Lien's pre-consent to DIP financing under IA not a bar to 1st Lien's

seeking approval of DIP financing on any other terms (even if less favorable

to 2d Lien)

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(f) 2d Lien providing its own DIP financing, including with a priming lien on its own

primary collateral (in a split-collateral deal) and on all other collateral

Note: Lien priority provisions in IA may not preclude 2d Lien from doing

so, unless "lien" is broadly defined to include any statutory,

judicial or contractual lien, whether created or arising before or

during BK case. 1st Lien on occasion (and reluctantly) may

consent to 2d Lien priming DIP with respect to specified types of

collateral or if 1st Lien declines to provide DIP financing in

amount sufficient to meet borrower's needs in BK case

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SALE OF COLLATERAL

1. 2d Lien's Consent

(a) 2d Lien asked to consent to any 363 sale (or plan sale) that is

consented to by 1st Lien (and vice versa in split-collateral deals)

(b) 2d Lien's acknowledgment of and consent to 1st Lien's credit bid rights

(and vice versa in split-collateral deals)

(c) Usually agreed to where 2d Lien has its own primary collateral, but

more difficult negotiation when 2d Lien is junior on all of collateral

2. Typical Consent Conditions:

(a) 2d Lien attaches to proceeds with same priority

(b) Excess over cap distributed per IA's waterfall provisions

(c) Proceeds permanently reduce 1st Lien debt

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Note: May be problematical if 1st Lien provides ongoing DIP

financing post-sale or elects (or is obligated) to fund a carve-

out

(d) 2d Lien's option to purchase 1st Lien debt triggered in 363 sale context

(e) 2d Lien preserves credit bid rights

Note: This could present problems if sale is free of all liens unless 1st

Lien debt is required to be satisfied, in cash, at time of

sale

(f) 2d Lien reserves right to object, on the same basis an unsecured

creditor could object, to fairness of bid procedures, timing and process

for conducting sale, and amount and method of payment of purchase

price

Note: If 2d Lien debt will not be paid in full from sale and 1st Lien

and 2d Lien encumber substantially all of the BK estate's

assets, objections to sale will usually be lodged by creditors

committee in any event

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ALLOCATION OF SPLIT-COLLATERAL PROCEEDS

1. Split-Collateral Structure: In a split-collateral deal, 1st Lien is usually first on

working capital assets (accounts, inventory, and customer lists, and certain

related intangibles) and 2d Lien is usually first on fixed assets, IP assets, and/or

equity interests in each Grantor

2. If IA is Silent on Allocation

(a) Parties risk that allocation in the purchase agreement may be adopted by a

court in an allocation contest

— Of course, a party may always withhold consent to a sale or

other disposition of its priority collateral

— However, in some federal circuits, a BK court may force a

sale of collateral under §363 for a price equal to what the court

determines the value of the collateral to be

(b) The BK court may determine allocation in a contested hearing based on

valuation evidence

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(c) If orderly liquidation values are used, 1st Lien’s inventory may have inconsequential

value divorced from IP (such as trademarks or tradenames) unless IA authorizes 1st

Lien’s use of IP

(d) How is the “going concern” premium to be allocated?

3. Some Allocation Options

(a) 1st Lien and 2d Lien agree to attempt to agree. In the absence of agreement,

1st Lien and 2d Lien agree to be bound by determination of a mutually agreed upon

valuation expert

(b) 1st Lien receives as deemed proceeds attributable to its priority collateral

consisting of

(i) accounts, the book or face value thereof,

(ii) inventory, the book value thereof (or the higher of book value and last

appraised value), and

(iii) all other 1st Lien priority collateral, the book value thereof (or value

determined by a mutually agreed upon valuation expert or a court, in

each case taking into account the methodology of sale (orderly liquidation vs.

going concern sale)), with deposit account balances included in the sale to be

shared in accordance with the tracing/priority rules established elsewhere in the

IA; and

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2d Lien receives any excess (which 2d Lien risks may be less than the value of

its priority collateral or may be lion’s share of going concern premium in a going

concern sale)

Note: Pegging the value of accounts at face amount may be

risky for the 2d Lien, as some accounts (especially in

a sale that is not a going concern sale) may be subject to

offsets, counterclaims, significant deductions or write offs.

2d Lien will likely bargain for book value, after giving

allowance for historical dilution and write offs.

Note: Limiting "accounts" to those items of 1st Lien priority

collateral that are rights to payment for good or services

may unintentionally overlook other payment rights in the

form of promissory notes, chattel paper, supporting

obligations, and general intangibles. Accordingly, the term

"payment rights" might be a better term as its definition in

the IA may incorporate not only accounts but also rights to

payment that are evidenced by or consist of instruments,

chattel paper or payment intangibles

Note: Be careful in use of "book value" as a valuation reference

for items of collateral that may be assigned an

unrealistically high value (such as intercompany claims) or

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no assigned value on the Grantor's books (such as a

customer lists)

(c) 2d Lien receives as deemed proceeds attributable to its priority collateral

consisting of fixed assets their value per most recent MAI appraisal and 1st Lien

receives any excess (which may be all or lion’s share of going concern

premium)

(d) The IA should provide that a sale of equity interests in a Grantor is deemed to

be a sale of the assets of the Grantor and the proceeds realized from any such

sale are to be allocated in the manner that would apply if there had been a sale

of those underlying assets

(e) Much of the formulation will depend upon the specific nature of the items of

priority collateral involved, the importance of those items to the overall business,

and whether such items have assigned to them any "book value"

E.g. — Working capital lender provides a revolving credit facility

to co-borrowers engaged in trucking business

— Each co-borrower grants working capital lender a

security interest in rolling stock and accounts

receivable

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— Term lender's loan to co-borrowers is secured by

intellectual property (assume nominally valued trade name

and website) and real estate of one co-borrower

— Co-borrowers file for BK and one without real estate sells all of

its assets, as a going concern, for $20 million

— Accounts receivable, at face value, total $5 million and

rolling stock has fair market value of $12 million

— Under some allocation formulations in an IA, the working

capital lender would receive only $17 million of total purchase

proceeds (face amount of accounts plus appraised value of

rolling stock), with the remaining $3 million representing the

"going concern premium" allocated to nominally valued priority

collateral of term lender

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FULL PAYMENT OF 1ST LIEN DEBT

1. Full Payment Condition

Full payment of 1st Lien debt is typically a condition to 2d Lien's exercise

of certain post-default rights and remedies

2. Definitions

"Full payment" should be defined and usually includes:

– payment of all 1st Lien loans;

– termination of the LOC;

– cash collateralization of (or supporting letter of credit for) certain

contingent obligations in liquidated amounts (e.g., letters of credit

and guaranties);

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– cash collateralization of (or supporting letter of credit for)

outstanding hedges (up to any cap on senior 1st Lien debt);

– termination (or acceptable credit support for ongoing provision) of

depository relationship and other cash management products;

– cash collateralization of (or lien retention for) pending or overtly

threatened claims (or until deadline for challenging liens or claims

under DIP financing order passes without a challenge);

– execution of full release of known and unknown claims against 1st lien by

borrower

Note: 2d Lien may object to “full release” requirement as likely

unavailable in BK case

3. Full payment requirement can be helpful to 1st lien in BK case when litigation is

threatened or ongoing

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2D LIEN'S PURCHASE OPTION

1. Reasons for Purchase Option

(a) Allows 2d Lien to “control its own destiny” when differing views exist

between 1st Lien and 2d Lien on direction of BK case (e.g., liquidation vs.

reorganization)

(b) Prevent 1st Lien’s exercise of credit bid rights in 363 sale

(c) 2d Lien "loan-to-own" strategy

2. Certain Drafting Issues

(a) What events trigger option?

(i) Acceleration of 1st Lien debt

(ii) Filing of BK case

(iii) Sale of assets with mandatory release

(iv) 1st Lien’s foreclosure of 2d Lien

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(b) How long does option remain open?

Note: 1st Lien wants a narrow window (say, 10 to 15 days) to exercise and will require in IA that option exercise is irrevocable

(c) Who can exercise option? Note: This is crucial where 2d Lien debt is held by multiple parties. Is option exercisable by 2d Lien agent for all or by any 2d Lien party (and, if so, first to act)? (d) What is to be purchased? Note: Is all 1st Lien debt to be purchased? Only the portion below the cap? 1st Lien should make sure 2d Lien is not allowed to purchase all 1st Lien debt, including excess over the cap, for a price equal to the capped amount; and DIP financing must be purchased as well, particularly if DIP loans do not prime 1st Lien's pre-petition position

•What is the price?

Note: Is price "par" or "market" and does it include prepayment or termination charges? LIBOR fees?

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(f) When is the closing?

Note: Important to 1st Lien that there be a short window to close

(say, 10 days)

(g) What are closing mechanics and terms of sale?

Note: Should address form of closing documents; and sale should

be for cash and without recourse except for breach of limited

warranties (e.g., ownership and authority to sell)

Other Issues

(a) Authority of 1st Lien to sell loans to others prior to 2d Lien's exercise of

option

(b) Right of 1st Lien to terminate cash management post-sale and resign from

any agency relationship in syndicated deal

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(c) 1st Lien's right to "roll over" or "roll up" in DIP financing (which may

eliminate purchase option)

(d) Non-assignability of purchase option by 2d Lien

(e) Failure or refusal of any 1st Lien lender in a syndicated deal to

cooperate (obligations of 1st Lien lenders to sell should be several

and not joint)

(f) 2d Lien's assumption of 1st Lien's funding obligations under credit

documentation and indemnification of 1st Lien for breaches

(g) Borrower's pre-consent in credit documents to purchase option

exercise (i.e., 2d Lien is an "Eligible Assignee")

(h) 1st Lien's authority post-default to cease lending or to exercise

remedies despite exercise of option

Note: Often limited to "exigent circumstances"

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CHAPTER 11 PLAN ISSUES

1. Voting

(a) 1st Lien's authority to vote 2d Lien claim

(b) 2d Lien's agreement to support plan supported by 1st Lien

2. Non-Support of Certain Plans

3. Reorganization Securities (the "X" Clause)

(a) Authority of 2d Lien to receive equity securities under plan

(b) Authority of 2d Lien to receive debt securities under plan

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FILO TRANSACTIONS

Overview

(a) FILO loans are documented under a common credit agreement with other loans

provided to the borrower (often by some of the same lenders), are secured by a

common lien with such other loans, and are fully funded at closing.

(b) By virtue of "waterfall" provisions in the credit agreement, FILO loans are "last

out" in the sense that other loans secured by the same lien have a first call on

collateral proceeds

(c) FILO loans are provided by lenders who are willing to provide lien subordinated

financings but are not institutionally able to provide "second lien" loans

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2. Risks

(a) The aggregate of the loans under a single lien may be treated in BK as a

single secured claim for purposes of § 506(a)(b). If treated as a single secured

claim and if total loans exceed collateral value, all lenders are undersecured in BK

(c) If lenders are undersecured in BK, §506(b) prevents recovery of post-

petition interest and expenses

(d) Waterfall provisions might be drafted, like a debt subordination, to

allow non-FILO lenders to recover interest and expenses (whether or

not allowed under § 506) from amounts otherwise payable to FILO

lenders

(e) In a DIP financing with a "roll over" or "roll up," the non-FILO lenders may

object to a roll over or roll up of the FILO unless the roll over or roll up

creates a FILO in equal amount in the DIP financing

3. Other Issues

(a) Whether bank products of non-FILO lenders receive

preferred treatment in the waterfall

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3. Other Issues

(a) Whether bank products of non-FILO lenders receive preferred

treatment in the waterfall

(b) What event triggers the waterfall (e.g., default, BK, acceleration,

enforcement action)

(c) Whether mandatory or voluntary prepayment of FILO loans are

permitted

(d) Voting rights and waivers on such issues as:

– BB issues (including advance rates)

– waterfall

– events of default

– voluntary prepayments

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