Publications: Silent Seconds' May Speak Up in Bankruptcy Court

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Although the volume of second-lien financings has skyrocketed from about $195 million in 1997 to more than $28 billion in 2006 (and is projected to well exceed those levels in 2007), there is a dearth of case law interpreting the chief document that governs the relationship between first- and second-lien lenders — the intercreditor agreement.

Coupled with recent evidence that investors’ appetites may be waning for generous lending terms typified by this asset class,1 parties to intercreditor agreements may want to take stock of how their rights will be viewed by the Bankruptcy Courts if their investments go south. There is little case law to guide a potential litigant in this arena. Not surprisingly, during the same time that second-lien financings were burgeoning, the number of corporate bankruptcies dropped dramatically. Accordingly, there are a few cases addressing the enforceability of bankruptcy waivers in intercreditor agreements.

Generally speaking, Bankruptcy Courts will enforce agreements that subordinate a second-lien lender’s right to payment from proceeds of collateral encumbered by both first and second lienholders.2 However, the authority is less clear when typical bankruptcy waivers of an intercreditor agreement are at issue.

Typically, intercreditor agreements purport to restrict or assign the ability of second lienholders to exercise fundamental bankruptcy rights. Second-lien lenders may be asked to waive their ability to seek adequate protection, or to object to the use of cash collateral or debtor-in possession (DIP) financing. Some courts hold that parties cannot waive fundamental bankruptcy rights and that Bankruptcy Code Section 510(a) was intended to address only the subordination of priority of payments.3

What follows is a brief discussion of some of the more common waivers encountered in today’s intercreditor agreements:

Adequate Protection. Typically, two aspects of adequate protection are at issue in secondlien intercreditor agreements: (i) senior lienholders often require the second lienholder to waive the right to seek adequate protection for the second lien; and (ii) senior lenders request a waiver by the seconds of the right to oppose adequate protection for first-lien creditors.

Adequate protection in the form of cash payments for second liens is permitted nfrequently; subordinated liens as adequate protection are more frequently permitted by senior lenders. However, several Bankruptcy Courts have refused to enforce pre-bankruptcy waivers of statutory rights.4 Therefore, although second-lien lenders frequently waive some of their rights, the enforceability of such waivers is questionable.

Second lienholders typically waive the right to oppose adequate protection for first lienholders. This waiver generally is not viewed as a significant concession because it usually is in the second lienholders interest that the first lienholders are paid.

DIP Financing/Cash Collateral. Second lienholders usually consent to a debtor’s use of cash collateral that is supported by the firstlien lender. A second-lien lender typically is not involved in the negotiations between the debtor and first-lien lender regarding the uses of cash collateral.

Second-lien lenders also usually consent to DIP financing approved by the first lienholders, especially when the first lienholders share the pain. However, it is not unusual for skirmishes to occur during negotiations over DIP provisions.

For example, in the recent New World Pasta case, the second-lien lenders challenged the approval of a DIP financing (and cash collateral and adequate protection) order based on the first lienholders’ inclusion of language that sought the de facto enforcement of the intercreditor agreement waivers. The dispute eventually was resolved, with each party fully reserving its rights to enforce/object to the waiver.

The New World Pasta case typifies how many conflicts are resolved in the early days of a bankruptcy case — by consensus. Because of the exigent circumstances that typically exist in the early days of a bankruptcy case, protracted litigation is usually not productive. However, in the next wave of bankruptcies, valuation disputes may be moved forward in the cases as the various constituents to a multilayered capital structure try to determine whether their positions are in the money. For example, in the Nellson Nutraceutical bankruptcy case, there was an early valuation of the debtor’s enterprise value as the constituents sought to determine whether a consensual plan was feasible.5

Voting Waivers. Although often requested by first-lien lenders, a second-lien creditor generally will not waive its right to vote on a debtor’s plan of reorganization. In fact, second-lien creditors vigorously resist any such provision. Although these provisions typically are not considered “market,” at least two courts have addressed the issue of whether a second-lien lender may waive its right to vote on a proposed bankruptcy plan, and they arrived at different results.

The first case, In re 203 N. LaSalle Street LTD Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000), considered whether an intercreditor agreement provision that allowed the first lienholders to vote the claims of the second lienholders was valid. The court held in this case that such a waiver was not permitted under the Bankruptcy Code because, inter alia, “subordination” under Section 510(a) refers to the ranking of claims and does not allow the waiver of substantive rights.

A recent case reached a different conclusion. In In re Aerosol Packaging, LLC, 2006 WL 4030176 (Bankr. N.D. Ga.), the Bankruptcy Court enforced an intercreditor agreement in which the junior creditor authorized the first lienholder to vote its claims in any bankruptcy proceeding. The court held that the Bankruptcy Code does not prohibit a party from negotiating away a substantive right. Although the Aerosol Packaging decision should give some comfort to first lienholders that voting right waivers will be upheld — indeed, the court squarely addressed the 203 N. LaSalle Street decision —the area is still unsettled, and such waivers are falling out of most intercreditor agreements today.

No Sure Bets

Despite the prevalence of second-lien financings in recent years, there is little case law to guide parties to intercreditor agreements. Thus, until there are additional judicial decisions interpreting the most common provisions of intercreditor agreements, creditors should consider their business goals carefully before subjecting their claims to the uncertainties of litigation.

1 In July 2007, several high-profile financings have been delayed, including KKR’s $28 billion buyout of First Data and Cerberus’ $20 billion acquisition of Chrysler. See The Daily Deal, July 25, 2007. Moreover, there is an abundant supply of leveraged loans. Standard & Poor’s Leveraged Commentary & Data estimates about $225 billion in leveraged loan value of forward supply.

2 See 11 U.S.C. Section 510(a) (“[a] subordination agreement is enforceable in a case…to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”); see also, e.g., In re Best Products Co., Inc., 168 B.R. 35, aff’d,, 177 B.R. 791, aff’d, 68 F.3d 26 (2d Cir. 1995).

3 See, e.g., In re Hinderliter Indus., Inc., 228 B.R. 848, 850 (Bankr. E.D. Tex. 1999) (“The intent of [Section] 501(a) (subordination) is to allow the consensual and contractual priority of payment to be maintained between creditors among themselves in a bankruptcy proceeding. There is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets.”).

4 See, e.g., In re Hart Ski Mfg. Co., 6 B.R. 734 (Bankr. D. Minn. 1980).

5 See, generally, George Mesires, “The Valuation Trial of Nellson Nutraceutial: Emerging Trends and Courtroom Basics,” ABI Journal, Vol. XXVI, No. 5, June 2007; see also, “Movie Gallery Plot Foreshadows a Testy Valuation Battle Among Second Lien Loans and Bonds,” FT.com, July 13, 2007; see also, July 6, 2007, press release from Bally’s Total Fitness announcing receipt of alternate restructuring proposal from equity investors who contend that equity position is in the money.