While in any mezzanine or second lien loan, the loan or investment agreement is the primary document setting forth the rights of the lender and the limits on the borrower, the intercreditor agreement between the junior lender and the senior lender severely restricts the junior lender’s exercise or enjoyment of its most important rights, including the right to payment of interest (and, if applicable, principal) and the right to call the loan and seize collateral. For this reason, it is paramount that junior lenders focus early in the negotiation of a loan on the details of the intercreditor agreement.
Junior lenders often encounter difficulty negotiating an intercreditor agreement for two main reasons. First, current practice is for the senior lender to provide the form of intercreditor agreement. This puts the junior lender and its counsel at an immediate disadvantage. The document is often tilted in favor of the senior lender because several key points are missing or improperly addressed. Second, and related to the first, the junior lender must seek changes to an approved form, often requiring approval – or claims that approval is required – from someone other than the representative from the senior lender that is negotiating the agreement. This can delay finalizing the agreement and apply pressure on the junior lender from the senior lender and borrower (and, if an acquisition, the equity player) to capitulate. Neither of these disadvantages are insurmountable and knowledge and careful planning can mitigate these negative pressures on the junior lender and result in a smoother negotiation.
Every junior lender should be aware of the key issues in intercreditor agreements and, of those issues, which are most important to the lender. The junior lender should focus on identifying these issues at the outset of a transaction to provide a checklist of items to be addressed in the intercreditor agreement. The following is a summary of key questions and, based on current practice, answers and guidance on each:
1. When and how should scheduled payments to a junior lender be limited? Nearly all institutional junior lenders require that the intercreditor agreement permit regularly scheduled payments of interest so long as the borrower is not in default under the senior credit agreement. However, the senior lender will require that it have the right, upon a default of the senior loan documents, to institute a blockage or standstill period during which the borrower may not make payments to a junior lender and a junior lender may not exercise its remedies, such as bringing suit, filing involuntary bankruptcy petitions and seizing collateral. The junior lender can protect itself in this regard in a number of ways.
First, payment blockages should be limited to payment defaults and defaults for which the senior lender has accelerated the loans. Other defaults, such as a breach of financial covenants or failure to provide required borrower certifications, should not be the basis for a payment blockage (unless the senior lender has exercised its right to accelerate the loan). Senior lenders will resist this position. Second, payment blockages should be for a limited duration – generally, 90 to 180 days depending on the nature of the junior capital. Third, for any particular default, there should be no more than one blockage. Fourth, the number of total permitted blockages should be limited, regardless of the number of defaults. Two blockages per year and three or four blockages during the life of the loan (depending on its duration) are customary. Fifth, although the junior lender will surrender many rights in a bankruptcy to the senior lender, it should make sure it has basic protections to accelerate its debts and perfect its remedies. Finally, care must be taken to determine when the payment blockage should begin. Senior payment defaults should result in an immediate blockage but other defaults should result in a blockage only after notice to the junior lender. On this point, the intercreditor agreement should properly reflect that the junior lender is only required to return payments received after the applicable blockage date (i.e., in most cases, only after receipt of notice). While a senior lender will suggest that some or all of these protections vitiate the subordination, they are necessary to insure that the senior lender does not sit on its rights to the detriment of the junior lender.
2. What is “Senior Debt” and may it be amended? A senior lender will require that the definition of “Senior Debt” be drafted broadly to make sure that it includes principal, interest, fees, costs and indemnity payments to insure that its priority over junior debt is complete. While this is generally acceptable, intercreditor agreements often permit the senior lender to amend the terms of its credit documents without the consent of the junior lender. These two provisions in concert could result in the junior lender being subordinated to an ever increasing amount of debt (whether the result of additional loans or increased interest or fees). The junior lender should negotiate, in the definition of senior debt, a cap on the amount of senior debt (including interest and fees) and confirm that the amendment provisions do not permit the senior lender to avoid the cap or materially change the terms of the senior loan.
3. What is “Junior Debt” and may it be amended? To further subordinate the junior lender, the senior lender will insist that the definition of “Junior Debt” also be broadly drafted to encompass any debt owed by the borrower to the junior lender, whether or not related to the current transaction. Again, while this is common, the junior lender should focus on two important transaction-specific items. First, there may be debt that should be excluded. Generally, this is not the case, but there are occasions, such as a short-term or limited purpose loan, when debt should be excluded from the definition of junior debt. Second, if the junior lender has a warrant or other equity component, the intercreditor agreement should be carefully drafted to preserve the junior lender’s power to exercise its basic equity holder rights, such as the right to vote as a shareholder during a blockage period. Additionally, it is advisable to provide the junior lender and borrower some flexibility to amend the loan or investment agreement. Amendments that, without the consent of the senior lender, would provide an unlimited increase in the loan amount, make the financial covenants more restrictive, change payment terms or increase the interest rate are generally not acceptable. However, many other types of amendments are permitted by a senior lender and having these rights can save time and expense later.
4. What collateral is subject to the subordination agreement? Intercreditor agreements generally provide that the senior lender has the first right to apply all of the collateral of a borrower to the payment of the senior lender’s obligations. However, a junior lender should be mindful of whether it has negotiated or received a special class of collateral that the senior lender has not included in its collateral base – such as a specific insurance policy in favor of the junior lender or a personal guaranty from a principal of the borrower. If so, the intercreditor agreement should reflect that the junior lender has the first right to this collateral and that it is not subject to the standstill.
5. How does a junior lender best protect itself? Once a junior lender has its checklist of key issues, it should try to address them as early in the process as possible. An effective way of doing this is to include these items in the term sheet with the borrower and request that the borrower clear them with the existing or proposed senior lender. Regardless of whether the key subordination terms have been included in a term sheet, request and review a copy of the intercreditor agreement at the outset of the transaction. Removing the pressure of time often allows the senior lender to seek any required approvals of changes to its form and for the junior lender and senior lender to negotiate a creative solution to a difficult issue. Obviously, working with senior lenders that are experienced in dealing with mezzanine or second lien lenders and familiar with the standard protections provided to junior lenders, or with which a junior lender has worked before, can go a long way toward easing the process.
By focusing on the issues most important to it and addressing them early, a junior lender can assure itself that it is protected in the regrettable, though all too likely, scenario that a senior lender seeks to exercise its rights under an intercreditor agreement.