Over the last few years, the European leveraged finance market has seen rapid growth of senior secured high yield notes (“SSN”) and senior secured covenant-lite term loan B (“TLB”) financings. A common feature of both SSNs and TLBs (together “Senior Secured Debt”) is that their terms typically permit the incurrence of senior unsecured debt by a borrower and its restricted subsidiaries (a “Credit Group”) subject to either satisfaction of a financial ratio or through various permitted debt baskets.
Historically, European financings have not addressed the intercreditor relationships between Senior Secured Debt and senior unsecured debt as the amount of senior unsecured debt permitted to be incurred has been limited to a relatively small fixed amount. However with the increase in flexibility to incur senior unsecured debt, we consider whether the lack of any agreed intercreditor agreement may impair the ability of senior secured lenders to realise recoveries from a European Credit Group in line with traditional expectations.
Senior unsecured debt— the US v European market
Current market documentation for SSNs and TLBs has been derived from the US market. The US market has not historically required senior unsecured debt to be regulated by an intercreditor agreement (ICA) because Senior Secured Creditors in the US markets have come to rely on a robust guarantee and security package from a US Credit Group together with a platform of settled US bankruptcy and finance law and, in particular, the framework of US Chapter 11 of the US Bankruptcy Code (Chapter 11). Through a Chapter 11 proceeding, as a sweeping generalisation, there will be a standstill on enforcement of debt and guarantee claims during the process and Senior Secured Creditors will generally recover value from a US Credit Group in priority to senior unsecured debt and benefit from the US bankruptcy court’s ability to “cram down” secured and unsecured creditors’ claims through a plan of reorganisation.
Compare this with a European Credit Group, where guarantee and security packages are generally much less comprehensive and/or of limited commercial value and/ or simply prohibited due to local law restrictions and there is no European wide equivalent to Chapter 11, with each European jurisdiction having its own insolvency regime. In such a case, senior unsecured debt incurred by a member of a European Credit Group that has not provided a secured guaranty (or has provided one of limited value, or secured by limited assets), may be pari passu or structurally senior to the Senior Secured Debt of the Credit Group, resulting in what may be an unexpected recovery in any restructuring or insolvency for the Senior Secured Creditors.
Contractual protections for Senior Secured Creditors in Europe
One option is for Senior Secured Creditor expectations v. senior unsecured creditor claims to be met in Europe contractually by way of an ICA. Contractual ICA arrangements are well known and settled in the European mezzanine, subordinated notes and/ or second lien markets. These could include:
- Standstill period or stay: to allow the Senior Secured Creditors an exclusive period of time during which to take enforcement action without interference
- Springing subordination: subordination of the senior unsecured debt to the Senior Secured Debt upon the occurrence of certain events, eg. insolvency or enforcement action
- Payment blockage: a restriction on payments to senior unsecured creditors on the occurrence of certain trigger events (such as major events of default) while the Senior Secured Creditors are taking enforcement action
- Release of guarantees/claims: release/assignment provisions permitting the security agent to release/assign claims of senior unsecured creditors against members of the European Credit Group, enabling the European Credit Group to be sold as a going concern on a debt-free basis
- Restrictions on borrowers and guarantors of unsecured debt: a prohibition or limitation on senior unsecured debt being borrowed in a structurally senior position to the Senior Secured Debt
What protections for Senior Secured Creditors are being implemented in Europe?
Whether to employ all or only some of the above features in ICAs with senior unsecured creditors will involve balancing their competing interests. Competing considerations have given rise to different intercreditor arrangements in recent deals involving European Credit Groups. Treatment of senior unsecured debt varies from having such debt fully subordinated to having it completely unrestricted by intercreditor arrangements. A common middle ground seems to be to require a satisfactory intercreditor agreement to be agreed at the time of incurrence of unsecured debt above an agreed amount, but this seems a poor result from a Credit Group perspective since it requires co-operation from the Senior Secured Creditors before future unsecured debt can be incurred. In any event, the mere fact of asking senior unsecured providers to sign into an intercreditor arrangement with the Senior Secure Creditors may inhibit the ability of a European Credit Group to execute quickly (or at all) senior unsecured financings.
As noted above, there is no current practice consistently applied in designing Senior Secured Debt transactions for European Credit Groups which permit the incurrence of senior unsecured debt. Features that are getting most market acceptance in Europe, and that we would suggest applying to senior unsecured creditors above an agreed level of materiality are intercreditor arrangements which would ensure that:
- Senior unsecured creditors are stayed and payment blocked for a certain period of time after an acceleration event has occurred under the Senior Secured Debt to allow the Senior Secured Creditors to conclude an orderly enforcement
- Senior unsecured debt is subject to release provisions which will enable the Senior Secured Creditors to sell the European Credit Group as a going concern, subject to valuation protections for the senior unsecured creditors
However, as Senior Secured Creditors become more aware of the issues, they may continue to push for the full suite of protections they have historically come to expect in the context of protecting their Senior Secured Debt position against unsecured or junior debt. This could mean that, European Credit Groups are in practice unlikely to be able to raise unsecured debt which is priced as genuine senior unsecured debt.
In contrast to senior unsecured debt, second lien debt and senior subordinated notes are well understood in the European market. Given that debt incurrence tests will often not differentiate between second lien and unsecured debt, it may be that European Credit Groups are able to maximise debt incurrence flexibility by ensuring intercreditor arrangements allow second lien and senior subordinated financings to be added to their capital structure on pre-agreed terms without having to seek future Senior Secured Creditor consent, rather than by focusing on the ability to incur senior unsecured debt.
A fuller version of this note, including a more detailed analysis of all the points raised can be viewed by clicking here.