Despite the prevalence of first-lien/secondlien structures in the loan market over the course of the recently-ended leveraged transaction cycle, fully-litigated cases interpreting the provisions of first-lien/second-lien intercreditor agreements remain something of a rarity. As a result, cases providing guidance on the extent to which customary waivers included in such intercreditor agreements would be enforced are always welcomed by finance practitioners. It comes as no surprise then, that the decision of Judge Peck of the U.S. Bankruptcy Court for the Southern District of New York in In re ION Media Networks, Inc. et al.1 has garnered so much attention. Much of the buzz stemmed from Judge Peck’s denial of standing to a second-lien creditor seeking to challenge ION Media’s proposed plan of reorganization. Judge Peck broadly enforced the second-lien creditors’ waiver, in an intercreditor agreement, of any right to claim that the senior liens were unperfected.

Judge Peck’s decision turned largely on his desire to uphold the bargained-for rights and restrictions that the lien holders had agreed to pre-bankruptcy, as well as his desire to preclude “obstructionist, destabilizing and wasteful behavior” by junior creditors seeking to boost their recovery in contravention of the previously agreed to allocation of rights.2

The ION Media decision thus provides strong support for the enforcement of pre-bankruptcy waivers and intercreditor agreements, which dictate with certainty the relative rights of each debt level across a particular capital structure. Nonetheless, because the Bankruptcy Court’s ruling concerned a unique species of property – FCC broadcast licenses – and all parties acknowledged uncertainty as to whether such licenses can be pledged as collateral, questions remain as to the lessons to be drawn from the case.

Background

ION Media Networks, Inc. (formerly Paxson Communications Corporation), a broadcast company, issued $725 million of secured first-lien debt and $405 million of secured second-lien debt back in the glory days of 2005. Both tranches of debt were secured by liens on substantially all of the assets of the company pursuant to a certain Pledge and Security Agreement. The Pledge and Security Agreement expressly included “FCC Licenses” in its description of “Collateral”, but separately excluded from the Collateral grant certain “Special Property” defined as “any permit, lease, license agreement or other personal property ... to the extent that any Requirement of Law ... prohibits the creation of a security interest therein.”3

The first-lien creditors and second-lien creditors entered into an intercreditor agreement (the “Intercreditor Agreement”)4 relating to their respective security interests in the shared Collateral. The Intercreditor Agreement provided, in pertinent part, that the priorities of the parties as to the Collateral would not be affected by “any nonperfection of any Lien purportedly securing” any of the obligations.5 The FCC Licenses, although included within the ambit of “Collateral” under the Pledge and Security Agreement, could also arguably be “Special Property”, and thus excluded from the grant of the security interest because of the prohibitions imposed by the FCC on the ability of license holders to grant liens on broadcast licenses. When ION Media entered bankruptcy, Cyrus Select Opportunities Master Fund Ltd. (“Cyrus”), holder of approximately $47 million in second-lien debt, attempted to capitalize on the FCC licenses and the potential hole in the security grant to the first-lien holders.

Throughout ION Media’s bankruptcy, Cyrus repeatedly fought against the ascription of any value to the first-lien creditors’ security interest in the FCC Licenses, and adopted what Judge Peck described as “aggressive bankruptcy litigation tactics as a means to gain negotiating leverage.” Indeed, Cyrus opposed the debtors’ DIP financing arrangements on the grounds that the arrangements improperly rolled up first-lien obligations on the strength of the first- lien creditors’ liens on the FCC Licenses. Cyrus later objected to the debtors’ proposed disclosure statement and plan of reorganization – which would have allocated most of the enterprise value in the reorganized debtors to the first-lien creditors by distributing 95% of the new stock to them – on the same grounds, asserting that the plan was unconfirmable because the FCC Licenses were unencumbered as a matter of law and that the disclosure statement did not contain adequate information to permit creditors to make an informed decision on the plan.7

Cyrus’ argument was relatively simple: The Intercreditor Agreement created a priority scheme limited to the Collateral in which a security interest was successfully granted under the Pledge and Security Agreement. In other words, it provided for the subordination of the liens of the second-lien lenders, but it did not provide for a debt subordination that affected the second-lien debt beyond the Collateral. Some or all of the rights related to the FCC Licenses were, according to Cyrus, excluded from the Collateral grant. To the extent the second-lien debt was underwater and the second-lien lenders’ claims were unsecured, the second-lien debtholders, along with other unsecured creditors, should share in the benefit of the unencumbered FCC Licenses. The waiver in the Intercreditor Agreement of the second-lien holders’ right to attack the perfection of the first-lien debt’s lien on the Collateral did not apply, Cyrus contended, because the FCC Licenses simply were not Collateral. If the Bankruptcy Court had agreed with Cyrus, second-lien lenders would have been able to share in the value of the unencumbered FCC Licenses on a pari passu basis with the first-lien lenders’ unsecured claims and other unsecured debt.

Much of the back-and-forth between the lenders probed the contours of permissible security interests in FCC broadcast licenses. The Bankruptcy Court refused to become enmeshed in the nature and scope of the security interest in the FCC Licenses, and instead simply relied upon the bargained-for terms of the Intercreditor Agreement to deny Cyrus standing to challenge the first-lien lenders’ liens in the FCC Licenses. Noting that the language in the Intercreditor Agreement precluded the second-lien creditors from challenging perfection of a lien “purportedly securing” any of the secured obligations, the Bankruptcy Court found that the FCC Licenses were properly covered by the waiver as “purported” Collateral, regardless of the extent to which the FCC lien analysis actually may have removed the FCC Licenses from the security grant. Indeed, according to Judge Peck, even assuming arguendo that the first-lien creditors’ security interests in the FCC licenses were invalid, because the parties had agreed “to establish their relative legal rights vis a vis each other” in the Intercreditor Agreement irrespective of the validity of the Collateral grant, the right to payment of junior creditors was still subordinated. On this basis, the Bankruptcy Court found that Cyrus did not have standing to dispute the validity of liens granted in favor of the first-lien lenders.8 Although Cyrus technically qualified as a “party in interest” in the chapter 11 case, the Bankruptcy Court honed in on the plain language of the Intercreditor Agreement and limited Cyrus’ ability to take action opposed to the rights of the first-lien lenders. And, because the proposed chapter 11 plan allocated substantially all of the debtors’ value to the first-lien lenders, and was thus consistent with the first-lien lenders’ rights, Cyrus was denied standing to object to plan confirmation.

Plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and creditor expectations should be appropriately fulfilled. The Intercreditor Agreement is an enforceable contract under section 510(a) [of the Bankruptcy Code], and the Court will not disturb the bargained-for rights and restrictions governing the second-lien debt currently held by Cyrus.9

The Bankruptcy Court’s decision boiled down to two competing public policy interests: that in favor of certainty in the enforcement of contracts between creditors on the one hand, and that in favor of the maintenance of the Bankruptcy Code’s scheme of settling claims among creditors (and the reluctance of some courts to enforce advance waivers at variance with that scheme) on the other hand. In weighing these, the Bankruptcy Court gave credence to the fact that the parties were sophisticated and specifically bargained for the terms of the Intercreditor Agreement:

Analysis

The Bankruptcy Court’s decision in ION Media may be interpreted as an implication that case law questioning the enforceability of intercreditor waivers should be limited to waivers of creditors’ voting rights on reorganization plans. Indeed, the Bankruptcy Court acknowledged that, due to public policy concerns, courts in other jurisdictions have refrained from enforcing pre-bankruptcy intercreditor agreements that restrict junior creditors from exercising certain bankruptcy rights, such as the right to vote on a reorganization plan.10 The Bankruptcy Court distinguished those cases on the basis that they often relate to voting waivers – plainly not the subject of the Intercreditor Agreement. The Bankruptcy Court further noted that nothing in the Intercreditor Agreement limited the right of Cyrus to appear as an unsecured creditor. This is particularly interesting given that Judge Peck found that Cyrus lacked standing to object to confirmation of the plan.

Although the first-lien lenders in ION Media did ultimately receive the benefit of the “purported” Collateral consisting of the FCC Licenses, the decision does not stand for the proposition that a clever intercreditor agreement will fill the gaps of a flawed collateral grant. The Bankruptcy Court noted that this was not a case where a lien perfection was mistakenly neglected. Rather, Cyrus’ position fell short because of Cyrus’ expectation that a first-lien/ second-lien intercreditor agreement would be strictly construed as pure lien subordination. But the Bankruptcy Court took a more practical, commercial view, and enforced the Intercreditor Agreement in accordance with the terms that were bargained for among the sophisticated creditor parties – without regard to whether those terms imposed lien subordination concepts, debt subordination concepts, or gradations of both. It remains to be seen whether this decision will signal a trend towards intercreditor agreements that further speak to debt subordination, as opposed to just lien subordination.

As seen in this case, purchasers of junior debt should be apprehensive of intercreditor agreements that have any degree of ambiguity and that could potentially be cleverly construed so as to strip a party of certain legal rights and remedies (such as standing). Acquiring debt at a discount can be a high risk strategy to begin with, but when the acquisition comes with strings attached the ability to turn the bargain basement purchase into a profitable return can be frustrated, as was the case here. Secondary purchasers therefore should scrutinize carefully any intercreditor agreements before purchase. Further, junior lien holders may want to bargain for more express terms describing the exclusion of assets not encompassed by the definition of “Collateral.” Meanwhile, for senior lenders who are party to intercreditor agreements that tie the hands of junior lenders, the ION Media decision may prove to be invaluable legal precedent.