A recent decision of the United States Bankruptcy Court for the Southern District of New York underscores the risk to junior creditors of not understanding fully the scope of consent given to a senior creditor to modify its senior lending arrangements with a debtor under the terms of an intercreditor agreement. In Buena Vista Home Entertainment, Inc. v. Wachovia Bank, N.A. (In re Musicland Holding Corp.),1 the Court held that the terms of an intercreditor agreement, which granted senior lenders substantial latitude to amend their revolving secured loan documents, without the consent of junior subordinated lien creditors, unambiguously authorized those senior lenders to bring in a new lender and secure that lender’s new term debt under their first priority lien in substantially all of the borrower’s assets to the detriment of the subordinate lien creditors.

In 2003, Musicland entered into a $200 million revolving credit agreement (the “Revolving Credit Agreement”), with certain lenders (the “Senior Lenders”), which was secured by a first priority lien in substantially all of Musicland’s assets, including all inventory and proceeds. The lien secured all “obligations, liabilities and indebtedness of every kind, nature and description” arising under the Revolving Credit Agreement as well as “all other agreements, documents and instruments now or at any time hereinafter executed and/or delivered by” Musicland in connection with the Revolving Credit Agreement. Shortly after entering into the Revolving Credit Facility, Musicland granted a group of its inventory suppliers (the “Secured Inventory Suppliers”) a subordinate lien on its inventory and proceeds thereof. The Secured Inventory Suppliers also agreed to subordinate their lien to that of the Senior Lenders pursuant to an intercreditor agreement.

In the fall of 2005, the Senior Lenders denied Musicland’s request to increase availability under the Revolving Credit Agreement. Musicland, however, was able to obtain additional financing from a new lender, Harris, N.A. (“Harris”), who agreed to make a $25 million term loan (the “Harris Loan”) to Musicland, but refused to advance funds under the Revolving Credit Agreement. The Harris Loan contained materially different terms than the Revolving Credit Agreement. Unlike the Revolving Credit Agreement, the Harris Loan was a short term loan, the debtor’s parent guaranteed repayment of the loan only to Harris, and the loan was to be repaid at the maturity date regardless of whether or not the lenders under the Revolving Credit Agreement were repaid. The Harris Loan was not documented as a separate loan because it would have been subordinate to the Secured Inventory Suppliers’ lien. Instead, Harris and the Senior Lenders documented the Harris Loan as an amendment to the Revolving Credit Agreement. This structure had the effect of incorporating the Harris Loan into the Senior Lenders’ facility and extending to Harris the protection of the Senior Lenders’ first priority lien in Musicland’s assets. The Senior Lenders did not seek the consent of the Secured Inventory Suppliers of this amendment to the Revolving Credit Agreement. Musicland repaid the Harris Loan in late 2005.

Shortly after repaying the Harris Loan, Musicland experienced a liquidity crisis and filed for chapter 11 bankruptcy protection. During the course of its chapter 11 case, the Court approved the sale of substantially all of Musicland’s assets. This sale produced sufficient proceeds to pay the Senior Lenders in full, but the Secured Inventory Suppliers were “substantially undersecured” and not paid in full.

In an effort to collect this deficiency, certain of the Secured Inventory Suppliers sued the Senior Lenders and Harris asserting a variety of claims, including breach of contract and tortious interference. The core allegation supporting the Secured Inventory Suppliers’ claims was that the intercreditor agreement did not allow the Senior Lenders to amend the Revolving Credit Agreement to bring the Harris Loan “within its priority and protection,” and that by doing so, the Senior Lenders and Harris diverted value that otherwise would have been available to pay the Secured Inventory Suppliers’ secured claims.

Harris and the Senior Lenders moved to dismiss the complaint contending that the intercreditor agreement expressly allowed the amendment to the Revolving Credit Agreement without the Secured Inventory Suppliers’ consent. The Court agreed and dismissed the complaint. In reaching this conclusion, the Court found that:

  • The intercreditor agreement “unambiguously authorized” the Senior Lenders to enter into the amendment and incorporate the Harris Loan into the Revolving Credit Agreement, and “thereby extend the lien priority granted” in favor of the Senior Lenders to the Harris Loan. 
  • The definitions in and provisions of the intercreditor agreement were “sufficiently broad on their face” to permit amendments that encompassed “any and all obligations, liabilities and indebtedness of every kind, nature and description” owing by Musicland “whether now existing or hereafter arising” under the Revolving Credit Agreement “and any amended agreement, including any new loans of any type made under any amended agreement.” Amendments “were not restricted to revolving debt.”
  • Amendments to the Revolving Credit Agreement were not restricted to the original Senior Lenders.
  • The Secured Inventory Suppliers were subordinated not only to the existing first lien lenders under the Revolving Credit Agreement, but also to “any other lender or group of lenders that at any time refinances, replaces or succeeds to all or any portion of the Revolving Loan Debt or is otherwise a party to the Revolving Credit Agreements.”
  • Finally, the Secured Inventory Suppliers had expressly waived notice of and consented in advance to “any amendment, modification, supplement, extension, renewal, or restatement of any of the Revolving Loan Debt or the Revolving Credit Agreement.”

Musicland illustrates the importance to subordinate lien creditors of fully understanding the scope of what a superior lien creditor is authorized to do under the terms of an intercreditor agreement. Authority to amend documents under an intercreditor agreement, even to change the fundamental character of those documents from revolving loans to term loans to the detriment of junior creditors, will be upheld where the language granting that authority is broad and unambiguous. The “expectation or understanding” of junior lien creditors will not overcome the language of an intercreditor agreement notwithstanding the fact that strict enforcement of that intercreditor agreement will result in significant adverse consequences to the subordinate lien creditors, particularly in situations where the borrower is in financial distress.