Book Review: Handbook on Second Lien Loans & Intercreditor Agreements
Written by: Jo Ann J. Brighton
Mark N. Berman
(American Bankruptcy Institute, 2009)
Reviewed by: Christopher S. Chow
Skadden, Arps, Slate, Meagher & Flom LLP; Wilmington, Del.
Have you ever wanted to get in on the ground floor of an emerging opportunity? Well, in case you weren't there when fire was discovered, you now have a second chance in the new ABI publication, Handbook on Second Lien Loans & Intercreditor Agreements, written by Mark N. Berman and Jo Ann J. Brighton. The subject of this beginner's handbook is concededly beyond the common experience of many new practitioners, but second lien loans are an increasingly common form of financing that restructuring professionals are likely to encounter frequently in practice both now and in years to come. Practitioners who therefore undertake to learn the language and complexities of second lien financing now will find themselves well-positioned to provide cutting edge advice to debtors and lenders alike as second lien financing issues take center stage in regular chapter 11 practice.
This handbook is a great place to start. Berman and Brighton begin by defining second lien loans and then placing in historical perspective their prominent role in many recent financing transactions. A second lien loan is a loan secured by the same collateral that secures a first lien loan; typically, second lien lenders rank junior in priority to first lien lenders because their liens are contractually subordinated to the payment in full of the first lien loan. Critically, second lien loans for a time surpassed unsecured mezzanine lending due in large part to relatively high interest rates and the prevalence of oversecured first lien lenders whose collateral possessed additional realizable value sufficient to realistically secure second lien loans. Under such conditions, second lien loans present a desirable alternative to other less secure or otherwise more volatile loan structures. In addition to focusing on second lien loans, the Handbook usefully goes through a brief discussion of other loan structures and strategies such as traditional mezzanine lending, first out first loss loans, PIK and PIK-toggle loans and loan-to-own strategy, the latter of which has recently come under some critical judicial scrutiny in the Ninth Circuit.
The heart of the Handbook, however, is its lengthy discussion of the intercreditor agreements that are commonly entered into between first and second lien lenders for the purpose of establishing the rights and obligations of these lender groups vis-à-vis each other. It is the intercreditor agreement that parties and courts often look to when disputes arise over the treatment of lenders' claims under a proposed chapter 11 plan or the relative rights of different lender groups to negotiate the terms of a refinancing with the debtor. This section of the Handbook is broken down into segments examining the provisions that appear most frequently and are negotiated most heavily in intercreditor agreements. Included in the discussion of each provision are illustrative examples of typical draft language negotiated between lenders.
For example, in order to obtain the funds it needs to continue operating its business after filing for bankruptcy protection, a typical chapter 11 debtor must seek its secured lenders' consent to the use of their cash collateral and obtain their consent to the debtor granting a senior priming lien to a new lender in order to obtain postpetition financing. After briefly introducing this topic, the Handbook addresses a common dispute over lender consent rights as it specifically pertains to second lien lending. By virtue of their liens in a debtor's collateral, which are co-extensive with a first lender's liens in the same collateral, second lien lenders are in a position to block a debtor's efforts to use cash collateral or obtain postpetition financing absent second lien lender consent, even when first lien lenders are themselves actively negotiating with the debtor to provide such financing. Reasonably anticipating that second lien lenders' blocking position may prove a significant barrier to a debtor's ability to continue operating in chapter 11 and quickly obtain new financing, senior lienholders often try to include provisions in the intercreditor agreement that provide in advance that second lien lenders will not object to the debtor's use of their cash collateral or obstruct postpetition financing efforts. To illustrate, the authors give various examples of draft intercreditor agreement language that provide for second lienholders' advance consent to the use of cash collateral and priming liens under certain conditions, such as upon the first lienholders' prior approval, or upon the requirement that postpetition financing documents refrain from proposing a specific plan of reorganization.
Numerous standard intercreditor agreement provisions are explored in this fashion, giving the reader a sense along the way of the types of disagreements that are likely to arise between lender groups. In their discussion of the purpose and importance of each provision, the authors engage in considerable back-and-forth analysis of the relative negotiating positions taken by first and second lien lenders when drafting modifications to standard intercreditor agreement language. Unsurprisingly, the first lien lenders generally try to maximize their ability as senior lenders to direct the course of a workout or chapter 11 reorganization without interference from the second lien lenders, while second lien lenders in turn attempt to maximize their ability to influence postpetition negotiations and ensure that their lending position is not eroded by the unilateral action of the first lien lenders.
Of particular interest for bankruptcy practitioners is the Handbook's section addressing the enforceability of various intercreditor agreement provisions in bankruptcy. A pivotal threshold issue to be considered is whether bankruptcy courts should have anything to say at all concerning the scope and validity of intercreditor agreements. Because an intercreditor agreement is, at its most basic level, a contract between two non-debtor parties, courts at times have taken the position that intercreditor disputes over the interpretation and enforcement of such agreements are more suited for disposition by state courts than the bankruptcy courts. Interpretation of intercreditor agreement provisions is therefore an area where case law appears relatively sparse and unsettled; practitioners who participate in drafting and litigating the intercreditor agreement provisions discussed in the Handbook may very well find themselves on the front lines of the development of new precedent. For example, several courts have considered whether an intercreditor agreement provision allowing a senior lender to vote a junior lender's claims in bankruptcy is enforceable. Although Bankruptcy Code §510(a) generally provides that subordination agreements are enforceable to the extent that such agreements are enforceable under applicable nonbankruptcy law, courts are split as to the enforceability of intercreditor voting rights provisions, particularly where the Bankruptcy Code's policy goals appear to be implicated.
Although the authors of the Handbook are to be commended for pursuing an introductory approach to the exploration and discussion of second lien loans and intercreditor agreements, greater dividends will be reaped by those readers who have at least a basic working knowledge of chapter 11 reorganization fundamentals and secured loan agreement provisions. Common bankruptcy concepts such as plan classification, adequate protection and cramdown are mentioned in passing as they relate to second lien financing, but are not discussed in detail, nor should they be expected to be, as such in-depth treatment requires substantial introductory discussion better suited to other general bankruptcy treatises. That said, because this is an introductory handbook, it could have benefited from the inclusion of a glossary to provide less experienced professionals with more information about some frequently referenced concepts such as waterfall provisions and the doctrine of marshalling.
On the whole, however, the Handbook accomplishes masterfully its goal of providing readers with a basic introduction to second lien loans and intercreditor agreements. In a span of less than 100 pages, the authors trace the rise of second lien loans, discuss alternative forms of financing, describe in detail the opposing concerns motivating first and second lien lenders in drafting key provisions of intercreditor agreements and explore what treatment intercreditor agreements receive in bankruptcy and current judicial controversies with respect to their interpretation. Brevity is a virtue in this regard. The Handbook's coverage of a considerably broad scope of material in a succinct fashion presents a low barrier to entry for practitioners who would like to get in on the ground floor of this complex but increasingly relevant area of emerging restructuring practice.