www. NYLJ.com ©2010 ALM Volume 244—NO. 25 thursday, August 5, 2010

SECURED TRANSACTIONS New ABA Model Intercreditor Agreement Offers Guidance

n intercreditor agreement is, as the name As larger amounts of institutional capital suggests, an agreement among different have flowed into the second loan market, of a common borrower that the dynamics of negotiating senior-junior loan specifies the relationship among the transactions have evolved. The junior lenders creditors, often addressing such issues have increasingly become sophisticated financial Aas priority of payments, of , institutions having bargaining power similar to that and actions in a of the borrower. This of the senior lenders, and they are represented column has tackled intercreditor and subordination by high-powered law firms experienced in large issues on several occasions over the past dozen By And commercial lending transactions. Yet, there has years.1 During that period, the institutional Alan M. Barbara M. been no market “standard” form of intercreditor Christenfeld Goodstein second lien market, and the corresponding agreement and little published guidance on the importance of intercreditor agreements, have issues that counsel should consider in drafting or grown enormously. Today we discuss the model capital that gives the lender the right to convert reviewing an intercreditor agreement. Periodically intercreditor agreement recently promulgated by the debt into an ownership or equity a titanic “battle of the forms” has erupted, each side an American Bar Association task force for use in in the borrower upon foreclosure or of proffering a draft intercreditor agreement that is negotiating intercreditor arrangements between the loan, and mezzanine lenders often receive favorable to it and often invoking its interpretation a lender or lending syndicate making commercial equity or warrants for equity in the borrower as of the nebulous and ever-shifting “market practice” loans secured by a first priority lien on specified a compensation “kicker.” to justify its position on contested issues. Inevitably, (first lien loans) and a lender or lending therefore, intercreditor agreements have become syndicate making commercial loans secured by a among the most complex and heavily-negotiated second priority lien on the same collateral (second Although the task force has not documents in commercial lending transactions. lien loans).2 As a result, the creditors have become obliged attempted to promulgate a “standard Background to invest significant time and effort negotiating form,” the model agreement promises to intercreditor arrangements and the intercreditor When this column addressed key issues be quite useful to practitioners and agreements found in the market vary greatly in for secured creditors in their clients. terms. Many market participants have voiced the arrangements in 1999, the structures that need to articulate a standard to reduce the time involved intercreditor agreements were much Both the right to payment of, and any liens and resources used in structuring intercreditor simpler than those employed in recent years. securing, both insider debt and mezzanine debt arrangements and to create a semblance of The subordinating then usually was are typically subordinated to the claims and uniformity from deal to deal. an insider of or investor in the borrower, rather liens of the borrower’s senior lenders. In second Recognizing the need for standardization than a financial institution seeking a return on a lien loan transactions, however, the second lien of intercreditor agreements, the Committee financing arrangement. Where the subordinating loans are with the first lien loans and on Commercial Finance of the American Bar creditor was a financial institution, normally it was only the liens securing the second lien loans are Association’s Business Law Section established an investment company, rather than a bank or subordinated. This significant feature of second the Model First Lien/Second Lien Intercreditor other commercial lender, that provided mezzanine lien lending has attracted many money-center Agreement Task Force (“task force”) in 1999. The financing. Mezzanine financing—a hybrid of banks and other large commercial lenders that task force’s mandate was to develop a “middle of debt and equity that sits midway between the have sought to enhance the yield on their loan the road” model intercreditor agreement that is two in a borrower’s —is debt portfolio while managing credit risk. It has also acceptable to both first lien holders and second drawn borrowers looking to finance themselves at lien holders. The task force developed a model an all-in cost lower than that charged in traditional through a series of discussions and reviews by mezzanine arrangements. As a result, the second lawyers who regularly have represented the lien loan market, barely an infant in 1999, grew to a three principal affected constituencies—first lien ALAN M. CHRISTENFELD is senior counsel at Clifford Chance lenders, second lien lenders and borrowers. The US. BARBARA M. GOODSTEIN is a partner at Dewey & volume exceeding $29 billion by 2006 and reached 3 LeBoeuf. EVAN J. COHEN, a partner at Clifford Chance US, $15.21 billion in the second quarter of 2007 alone. task force’s final Model First Lien/Second Lien co-authored this article, and CHONG KIM, an associate at Moreover, it spread from large leveraged loans to Intercreditor Agreement (“model agreement”), the firm, assisted in its preparation. the middle-market and asset-based loans.4 together with a covering report, annotations thursday, August 5, 2010 and commentary, was published in the May 2010 practitioners and their clients. Since the model whether second lien loans regain their pre- edition of The Business Lawyer.5 provides ample footnotes and comments that financial crisis prominence or are replaced in The New Model Agreement highlight the most commonly-negotiated issues, whole or in part by mezzanine loans, the lien both legal and commercial, it will function as a subordination issues that the senior and junior The model agreement, with annotations and helpful checklist of issues to review and consider lenders will confront will remain largely the same. commentary, occupies nearly 75 densely printed when structuring and negotiating a first lien/ Moreover, many first lien/second lien credits pages, and it covers dozens of issues that could second lien intercreditor arrangement. remain outstanding. Accordingly, the model be the subject of loan origination and post-default The model agreement can also serve as a agreement should remain relevant irrespective negotiations. Space limitations compel us to starting point for negotiations between the parties, of how the institutional subordinated debt markets confine our discussion here to the broad intent providing guidance as to the range of industry- evolve in the future. and purposes of the model agreement. Readers acceptable results of the issues that are commonly The model agreement is the product of interested in the new model’s details should, of debated. In many of its provisions, the model years of give and take by lawyers who regularly course, review the model agreement, annotations agreement explains the different options that represent the principal players in the first lien/ and commentary in their entirety. the market has observed for such provisions in second lien market. Although the new model does When first evaluating the model agreement, past transactions and offers alternative business not supply a solution for every issue that first one needs to bear in mind what the new model options— either first lien friendly, second lien lien and second lien lenders could encounter is not. Created in large part to address the issues friendly or neutral—and language implementing in a financing transaction, it highlights the key concerning the relationship between first lien the different choices. Being a model, of course, issues to consider when dealing with intercreditor holders and second lien holders with a borrower it supplies well-vetted and accepted language to agreements, provides guidance for market practice and collateral in common, the model agreement memorialize in the intercreditor agreement the regarding intercreditor relations and furnishes does not address the issues arising from mezzanine results of the parties’ business negotiations. It drafting language for various alternative business or other lending arrangements, such as payment remains to be seen whether the model agreement arrangements. One hopes that it will gain wide subordination. Even with respect to second will enable senior and junior lenders to reduce acceptance among financing lawyers and clients. lien debt financings, the model is not intended the time and effort they spend negotiating, but In any event, the model agreement is required to cover all factual permutations or varying it should facilitate drafting the agreed provisions reading for everyone who engages regularly in business arrangements in such transactions. As and thereby save time and expense. first lien/second lien transactions. the task force clearly states, the model agreement Moreover, the model agreement ought to ••••••••••••••••••••••••••••• should not be used as “a universal solution to facilitate the management of client expectations. the problem of identifying the ‘correct form’ to The players in first lien/second lien financing 1. See Alan M. Christenfeld & Shephard W. Melzer, use for a transaction. The form will necessarily transactions sometimes have unrealistic “Navigating the Second Lien Financing Market,” NYLJ, Oct. be determined by the details of the transaction.” expectations, especially if the deal is relatively 6, 2005 at 5; “An Introduction To Intercreditor Agreements,” Nevertheless, although the details of different first small or if one of the lenders is new to this type N.Y.L.J, April 4, 2002 at 5; and “Subordinated Debt: Key Issues lien/second lien financing transactions vary in of transaction. A first lien lender might consider for Senior Creditors,” NYLJ, Oct. 7, 1999, at 5. many ways, the task force notes that nearly all the second lien lender philosophically to be an 2. Committee on Commercial Finance, ABA Section of intercreditor agreements dealing with priority equity holder with a lien (rather than as a pari Business Law, Report of the Model First Lien/Second Lien of liens in common collateral must necessarily passu lender that is merely subordinating its Intercreditor Agreement task force, 65 Bus. Law. 810 (May address similar lien subordination issues as well lien), while the second lien lender might view 2010) (“ABA Report”). as the effect of the intercreditor terms both in itself to be a senior lender with a higher coupon. 3. Id. at 810 (citing LoanConnector, www.loanconnector. and out of bankruptcy proceedings involving Either such party might then make requests that com (downloaded April 1, 2010)). the borrower. “While there will be structural are inconsistent with the nature of the actual 4. A typical structure in a middle-market or asset-based differences in the transaction itself, the same intercreditor relationship. The development of a loan is for a revolving lender to hold a first lien on all accounts, issues will be present.”6 model document that is the product of discussions inventory and other current assets while a term lender holds a Accordingly, the model agreement and among various participants in the first lien/second first lien on equipment, real estate, and other fixed assets, with accompanying comments, other footnotes and lien market should help practitioners to anchor each lender also taking a second lien in the other’s primary text “are intended, first and foremost, to be a the intercreditor expectations of their clients in collateral. “Variations of such ‘wrap’ structures have become reference tool for practitioners.” The model reality. increasingly creative.” Id. agreement “introduces the major components of Conclusion 5. See ABA Report, supra n.2. lien intercreditor agreements generally, addresses 6. Id. at 810-811. why such provisions are necessary, and explores As with other forms of financing, the volume 7. Id. at 811. the effect of drafting a provision in a manner more of second lien lending fell sharply during the 8. Id. at 810. favorable to a first or second lien lender.” The financial crisis in 2008.8 Recent first lien/second 9. See “Prospect Capital Makes $20 Million Secured Debt comments, in turn, explain the general purpose lien financings have been much smaller than those Investment in Hoffmaster,” Marketwire (June 3, 2010), http:// of each section, highlight the principal issues in vogue before the onset of the “Great Recession,” www.marketwire.com/press-release/Prospect-Capital-Makes- encountered in practice and purport to convey as illustrated by the $20 million second lien 20-Million-Secured-Debt-Investment-in-Hoffmaster-NASDAQ- prevailing market expectations. “Armed with financing of Hoffmaster Inc. by Prospect Capital PSEC-1270445.htm (last visited July 28, 2010). an understanding of these basic concepts and Corporation announced last month.9 However, 10. See, e.g., Richard Kellerhals, “Mezzanine Debt Draws their implementation in the Model Agreement, when the economy and commercial loan markets Investor Interest,” Investment Dealers Digest, June 18, 2010 the practitioner may construct an intercreditor improve, the demand for a tranche of institutional at 6. agreement that fits his or her transaction.”7 debt that is subordinated in some manner to the Potential Benefits senior loan but yields a higher coupon is likely to increase. Some industry experts have predicted Although the task force has not attempted that the next wave of institutional subordinated Reprinted with permission from the August 5, 2010 edition of the NEW YORK LAW to promulgate a “standard form,” the model JOURNAL © 2010. ALM Media Properties, LLC. All rights reserved. Further duplication tranche will take the form of mezzanine loans without permission is prohibited. For information, contact 877-257-3382 or reprints@alm. agreement promises to be quite useful to rather than second lien liens.10 Nevertheless, com. # 070-08-10-11