When structuring a complex debt financing, financiers need to consider whether unsecured and structurally subordinated “mezzanine” debt ought to be replaced in the capital hierarchy with secured second lien credit. The relatively lower financing cost for second lien credit is based on the assumption that the second lien lenders might obtain some equity value from the liens on the residual collateral which would not otherwise be available with such “mezzanine” debt. Requests for second lien status also arise when these lenders have their own credit facility and need such liens to increase their borrowing base. In exchange for such status, senior lenders often require such liens to be a “silent second” with minimal or no enforcement rights. A properly drafted intercreditor agreement among the parties to the transaction is necessary to ensure that their relative rights and obligations are enforced in a distress or bankruptcy situation.
Defining lien priority as between two secured creditors is necessary when both have security interests in the same collateral. The reason is that the senior lender will seek to be repaid first from proceeds of collateral upon enforcement of the lien, while the junior lender will expect to collect only from any remaining proceeds. If the collateral proceeds are not sufficient to repay the senior lender in full, then both secured creditors and all other unsecured creditors would rank equally in their right to repayment of remaining indebtedness from the other assets of the debtor. Payment subordination provisions in the intercreditor agreement mitigate this result in favor of the senior creditor. Payment subordination allows the senior creditor the right to be paid first from all assets of the debtor or any other obligor of the debtor, regardless whether such assets constitute collateral security. The amount owed to the senior lender drives payment subordination terms, not the value of the pledged collateral. Provisions in the intercreditor agreement typically require all parties to pay-over to the senior creditor or its agent any proceeds obtained from shared collateral.
Setting forth lien priority in intercreditor agreements also serves to mitigate against the risk of the senior creditor not being “first in time” in filing a lien. The intercreditor agreement should require something to the effect that, notwithstanding the date, time, method, manner or order of grant, attachment or perfection of liens securing the senior or junior obligations, etc., the lien in favor of the senior creditor shall be senior in all respects and prior to any lien on collateral securing the junior obligations. Both creditors’ counsel should nonetheless diligently observe all perfection requirements during the closing process to protect collateral from unsecured claimants. Finally, the intercreditor agreement should require that parties will not challenge each other’s lien and payment priority as set forth in the agreement.
Given their respective lien priorities, a second lien creditor’s prospects of recovery from common collateral may significantly decrease if there is an increase in the amount of the first lien creditor’s obligations. To avoid this “cram down,” junior creditors typically seek explicit limits on the types and amounts of senior obligations that may be secured by the first lien on the common collateral, which terms are heavily negotiated. A second lien creditor may seek to entirely exclude items such as unaccrued original issue discount, that portion of interest accruing at the incremental default rate and certain fees and expenses. In addition, the second lien creditor typically seeks to impose a dollar-defined cap on the overall principal amount of the first lien obligations. Hedging obligations which are part of the senior obligations may vary dramatically and may increase the dollar-defined cap. For cross-border deals or transactions with collateral foreclosure in different countries, currency exchange and fluctuation should be addressed in the intercreditor agreement. Incremental credit facilities such as refinancings or increases in credit extensions (e.g., “accordion” facilities), and priming loans and debtor-in-possession (DIP) loans in a bankruptcy context may also be subject to the overall cap. Similarly, interest and various fees, costs, indemnities and other expenses may also be subject to a different cap or put into the same basket. A way to allow the senior creditor to have sufficient room to extend additional credit to a debtor in distress is to permit such additional obligations to about 10 to 15 percent of the initial principal amount of the senior debt, with perhaps a second, additional cushion if bankruptcy proceedings have commenced and a DIP loan is being extended by the senior creditor. The cap on the principal amount of senior obligations should be automatically and irrevocably reduced upon repayment of principal to the senior creditor under its facilities.
The purpose of these limitations is to subordinate to the lien of the second lienholder that portion of first lien obligations which are in excess of the cap, which results in third lien priority for such excess obligations of the senior creditor. Similarly, any right of the second lienholder to buy out the first lien creditor’s debt would be limited to amounts up to the first lien cap, not the excess. First lien creditors would want to impose a corresponding cap (and related terms) on the second lien obligations for the same reasons. In doing so, the parties typically draft “waterfall” provisions to capture the priority levels.
Another basic principle of intercreditor arrangements is that the senior creditor is typically entitled to control the maintenance and disposition of common collateral while the junior creditor is required to waive certain statutory rights that would otherwise entitle the junior creditor to challenge the enforcement and foreclosure process. A “standstill period” is typically imposed, which grants to the senior creditor the exclusive right to enforce and exercise remedies over the debtor for a defined period of time. The number of standstill periods allowed during the lifetime of the loan is usually the subject of negotiation between the senior and junior creditors. Each standstill period is usually 90 to 180 days during the lifetime of the loan, with extensions of additional periods so long as enforcement actions are being diligently pursued. To expedite and streamline collateral realization, the grant of exclusivity in favor of the senior creditor may be subject to specific conditions, such as a requirement that the senior creditor select and retain the services of a qualified independent appraiser for valuation of the collateral or an experienced investment banker to run an auction process for the efficient sale of collateral. The same conditions may apply to the junior creditor if and when it takes over the process at the expiration of the standstill period in respect of unrealized common collateral. The second lienholder typically retains only the right to file a claim and to demand and accelerate its loans so as to preserve its status ahead of (or at least no worse than) all unsecured claimants. Whether the second lienholder is granted the right to consent to dispositions of common collateral under the bankruptcy process is usually hotly negotiated. A comprehensive intercreditor agreement which provides sufficient clarity around the collateral realization process and reasonable limitations on the senior creditor’s rights is often sufficient to keep the junior creditor in the fold.