In recent years, second lien financings have increased in popularity. Senior creditors rely on intercreditor agreements to protect their interests by limiting the rights that junior lien holders would otherwise enjoy as secured creditors through either lien subordination, payment subordination, or both. Lien subordination requires the turnover to first lien creditors of proceeds of shared collateral until the first lien holders are paid in full. In a lien subordination arrangement, if the proceeds of the shared collateral are insufficient to pay the first lien creditors in full and there is unencumbered collateral, the deficiency claim of the first lien creditors and the unsecured claim of the second lien creditors share pro rata (along with other unsecured claims).
By contrast, under a payment subordination scenario, senior creditors enjoy the right to be paid first from all assets of the borrower or any applicable guarantor, whether or not constituting collateral security for the senior or subordinated creditors. Because the senior creditors’ recovery under payment subordination depends only upon the amount owed and not on the value of any particular collateral, it is a deeper form of subordination. Typically, the junior creditors retain all of their rights and entitlements as an unsecured creditor where there is no claim subordination. Unfortunately, these provisions vary from intercreditor agreement to intercreditor agreement.
The recent decision in In re MPM Silicones, LLC, Case No. 14-22503 (RDD) (Bankr. S.D.N.Y. Sept. 30, 2014) (Momentive) highlights additional pitfalls in the limited protection provided to senior lenders by lien subordination, as compared to the more advantageous payment subordination. The Momentive decision reflects the recent trend towards strict or narrow construction and interpretation of intercreditor agreements. In Momentive, the Bankruptcy Court dismissed the senior lien holders’ arguments, holding that (1) turnover to the first lien holders was not required because the equity distributed to second lien holders under the plan did not constitute “proceeds” of common collateral and (2) entering into the restructuring support agreement, supporting the debtors’ cram down plan, and intervening in the make-whole dispute did not violate the intercreditor agreement because the second lien holders were acting within their rights as unsecured creditors in disputing the amount and treatment of the senior lien creditors’ claims, rather than pursuant to their rights in the shared collateral.
On April 13, 2014, MPM Silicones, LLC and certain debtor affiliates (the Debtors) filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code. Prior to the petition date, certain of the junior lien holders entered into a restructuring support agreement with the Debtors which served as the basis for the Debtors’ plan (the Plan).
Under the Plan, the senior lien holders will receive new debt instruments secured by the prepetition common collateral. The junior lien holders will receive new equity in the reorganized debtors. The senior lien holders voted to reject the Plan, requiring the Debtors to seek to cram down the Plan over their objections. At the Plan confirmation hearing, the Bankruptcy Court overruled the senior lien holders’ objections (including their make-whole objection discussed more fully in a prior alert available here), and confirmed the Debtors’ Plan.
Concurrent with the Plan litigation in bankruptcy court, in June 2014, the senior lien holders filed a lawsuit in New York state court accusing the junior lien holders of violating the terms of the intercreditor agreement. These actions were ultimately removed to district court over the senior lien holders’ opposition, which automatically referred the matter to bankruptcy court.
The complaint filed by the senior lien holders sought recovery for breaches of the intercreditor agreement by the junior creditors through turnover of stock and backstop fees distributed to the second lien holders under the Plan, plus an unspecified amount of damages. Specifically, the complaint alleged that entering into the prepetition restructuring support agreement, supporting confirmation of the Plan, supporting the debtor in possession financing, and intervening in the make-whole litigation on behalf of the Debtors violated the intercreditor agreement’s provisions prohibiting the second lien holders from exercising rights or remedies, or objecting to relief sought by the senior lien holders. Additionally, in the complaint, the senior lien holders alleged that the proposed payments to the junior lien holders under the Plan, including the stock in the reorganized debtors, reimbursement of professional fees, and the potential $30 million fee for backstopping a rights offering, violated the intercreditor agreement because the senior lien creditors were not paid in full in cash under the Plan.
The second lien noteholders filed a motion to dismiss the complaint arguing that the intercreditor agreement only barred the second lien holders from taking, or requiring them to take, specific actions relating to enforcing their liens against the common collateral or otherwise exercising any right or remedy relating to the common collateral. Since none of the alleged conduct related to the common collateral, there was no violation of the intercreditor agreement.
After oral argument, the Bankruptcy Court issued a lengthy bench ruling against the senior lien holders and granted the junior lien holders’ motion to dismiss the claims. First, the Bankruptcy Court dismissed all claims arising from the second lien holders’ support of the Plan and intervention in the make-whole litigation. Because the junior lien holders’ actions did not interfere with the senior lien creditors’ rights in the common collateral, but rather the amount and treatment of the senior lien holders’ claims in the Chapter 11 cases, the Bankruptcy Court concluded there was no violation of the express terms of the intercreditor agreement. Further, the intercreditor agreement explicitly preserved the second lien holders’ rights as unsecured creditors of the Debtors. By virtue of their sizeable deficiency claim, the Bankruptcy Court concluded that the junior lien holders’ support of the Debtors’ challenge of the senior lien holders’ entitlement to the make-whole provision and the cram down Plan was consistent with their rights as unsecured creditors preserved by the intercreditor agreement.
The Bankruptcy Court also dismissed the causes of action for turnover of Plan payments — stock in the reorganized debtors, reimbursement of professional fees, and the potential $30 million fee for backstopping a rights offering — to the senior lien holders. As a matter of law, the Bankruptcy Court rejected the notion that the stock in the newly reorganized debtors was proceeds of the common collateral. Rather, the Bankruptcy Court recognized that the stock was provided on account of the rights arising out of the junior lien holders’ liens and claims, and not on account of the common collateral or based on any rights arising from the common collateral.
Under the confirmed Plan, the first lien holders continue to retain their liens on all of the common collateral. Therefore, the Bankruptcy Court reasoned that not only has the common collateral not been diminished by the distribution of new stock under the Plan, but distribution of the stock to junior lien holders actually improves the position of the first lien holders with respect to the common collateral. With respect to the $30 million backstop fee, the Bankruptcy Court concluded that the backstop payment is a separate, unsecured obligation of the Debtors in exchange for the junior lien holders’ agreement to backstop new exit financing for the Debtors. Therefore, such payment is not a remedy of the junior lien holders against common collateral and does not violate the intercreditor agreement. Finally, because it had not been properly pled, the Bankruptcy Court could not discern the basis for payment of the professional fees and, therefore, dismissed the claim without prejudice on that basis. The Bankruptcy Court, however, did not rule that the junior lien holders’ right to retain those fees is under no scenario implicated by the intercreditor agreement.
With respect to the second lien holders’ alleged wrongful opposition to adequate protection, the Bankruptcy Court dismissed the claim without prejudice, concluding that the claim was not pled with sufficient specificity.
Thoughts and Solutions
The ruling in the Momentive case is consistent with other recent decisions on the topic of enforceability of intercreditor agreements and their legal limitations in restricting junior lien creditors in the bankruptcy context. This decision highlights the shortcomings of lien subordination over the more advantageous claim subordination. Despite being oversecured, the lien subordination provisions did not adequately protect the interests of the senior lien holders and resulted in the junior lien holders’ retention of significant value under the Plan.
Moreover, the decision underscores the importance of a carefully drafted intercreditor agreement. Where creditors agree to lien subordination but not claim subordination, the relative rights and entitlements of the senior and junior creditors need to be precisely set out in the intercreditor agreement. In order to effectively prevent junior creditors from taking positions adverse to senior lien holders, it is critical that the intercreditor agreement be as explicit as possible in listing the specific bankruptcy rights to be silenced rather than relying on general language. Further, any provision permitting junior creditors to retain the rights of unsecured creditors should be narrowly tailored to ensure the provision cannot be broadly construed to undue any protections afforded to the senior lien holders. What remains unresolved is whether this decision (and other similar decisions) moves the market when it comes to how intercreditor agreements are drafted. While senior lien holders may try to scale back the typical provisions that preserve the junior lien holders’ rights as unsecured creditors, that may prove to be difficult as a practical matter. These provisions have, in recent years, been elevated to “boilerplate” or sacrosanct status by parties negotiating intercreditor agreements, and thus any pushback as a result of the Momentive decision described above may prove challenging.
Indenture trustee or agents, whether for senior or junior debt, should first analyze and fully understand the relative rights of creditors under an intercreditor agreement before taking or omitting to take any action.
The Momentive decision also provides useful guidance regarding the level of detail required to be pled in order to withstand a motion to dismiss. Absent the pleading of sufficient facts relating to the breach of the intercreditor agreement (e.g., specific facts evidencing the junior creditors’ breach, the actions taken by the junior creditors in violation of the intercreditor agreement, the provisions of the intercreditor agreement violated, etc.) the complaint will be at risk of dismissal on the basis that the claim was not pled with sufficient specificity.