Number 382 April 15, 2004

Client Alert

Latham & Watkins Corporate and Finance Departments Second Lien Financings—Answers to the Most Frequently Asked Questions The purpose of this client alert is to the two most common forms of this new answer some of the most frequently product which are being sold in the asked questions about second lien capital markets—second lien term loans financings. These financings have designed for sale in the institutional become increasingly popular over the loan market and second lien high yield last year or so, and we think they offer a bonds. As we discuss below, there are financing alternative that will remain on many similarities between these two the menu for years to come. There is a products. However, there are also a distinct lack of agreement in the market number of important differences. regarding some of the critical issues that At the end of this client alert, we have bankers and lawyers structuring these included a chart summarizing the key deals must address, and so we will not issues to address in structuring a second always offer a single answer for each of lien financing. The chart indicates how the questions we pose. However, there those issues are currently being There is a growing is also a growing consensus among the “ resolved in the debt markets. consensus among members of the finance community on many of these questions and we are the members pleased to report on that consensus as What is a Second Lien Term Loan? of the finance we see it. A typical second lien term loan is a “term loan B”1 secured by a lien on community on Perhaps the best place to start the substantially all of the borrower’s assets. dialogue is with the question “What is a many of these In some cases, the term loan B will be second lien financing?” The answer to questions and secured equally and ratably with a pari that simple question is surprisingly passu tranche of secured bonds. we are pleased complex. Some second lien deals are Alternatively, the term loan B might be secured mezzanine financings with to report on that the only second lien debt in the capital equity kickers. Others involve seller consensus as structure. In either event, the term loan paper issued in acquisitions to the B lenders will almost certainly be we see it.“ former owners of the acquired business sharing the capital structure with at or notes issued to the borrower’s equity least one other credit facility of the more owners. Still others involve asset-based traditional variety—possibly just a lenders secured by a first lien on current revolver or possibly a term loan and assets and a second lien on property, revolver—secured by a first lien on plant and equipment sharing the substantially the same collateral. The balance sheet with high yield bonds second lien term loan is denominated secured by a first lien on property, plant “second” because the two classes of and equipment and a second lien on creditors agree that, in the event any of current assets. The variations are their shared collateral is ever sold in a endless. In this client alert, we focus on

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foreclosure or other enforcement action, the capital markets at all. Some either before or during a bankruptcy borrowers may also perceive holders of proceeding, the “first lien” credit facility second lien debt to be potentially less (and all other “first lien” obligations, if “volatile” in a distress scenario than any, that are then outstanding) will be unsecured creditors to the extent those entitled to be paid in full before any of holders believe they are sufficiently the proceeds from the shared collateral secured to successfully ride out a period sale will be distributed to the “second of poor financial performance. lien” term loan lenders. The second However, there are costs to the borrower lien term loan is not contractually associated with providing collateral to subordinated in the traditional sense the holders of its junior debt. First, as (i.e., payment subordination), but it is part of the deal structure, the second subordinated in its claim to the proceeds lien covenant package will likely impose of the shared collateral. a more restrictive cap on the amount of additional first lien debt that may be What is a Second Lien Bond Deal? incurred in the future than would appear In its simplest form, a second lien bond in an unsecured high yield bond deal is much the same as a second lien indenture. In addition, depending on the term loan—it involves a bond deal value of the collateral and the cash flow secured by substantially all of the of the enterprise, the borrower’s ability issuer’s assets where the bondholders to obtain first lien financing in the have agreed with the holders of “first future may be impaired by the presence lien” debt that they will be second in of a significant tranche of second lien line as to distributions of proceeds from secured debt on its balance sheet. sales of shared collateral. As in the case Further, the total amount of additional of second lien term loans, the typical second lien debt that may be incurred in second lien bond deal is not the future will also be capped, usually contractually subordinated in the based on a maximum leverage ratio or traditional sense. The bonds are only other financial test. Finally, it may be second in line with respect to the harder for the borrower to tap the proceeds from sales of shared collateral. unsecured debt market in the future These bonds are usually called “senior because future unsecured creditors of secured notes” or “second lien senior the borrower would be effectively secured notes” or some similar variation subordinated to all of the second lien on that theme. debt.

What are the Pros and Cons of a Why Would a First Lien Creditor Second Lien Deal for a Company? Want to Permit a Second Lien Deal? A borrower should get better pricing on In general, first lien lenders do not favor a second lien financing than it would by providing collateral to junior creditors. incurring unsecured debt on However, in some cases the proceeds substantially the same terms. In from the second lien deal are needed to addition, a borrower will get broader make a transaction feasible or are access to the debt markets because of earmarked to pay down first lien debt or the tremendous interest in second lien will effectively limit the amount of first paper across a range of institutional lien debt needed going forward. With a investors, including financial lower level of credit exposure, the first institutions, insurance companies, lien lenders may become significantly mutual funds, CBO, CDO and CLO funds more flexible and the increased and hedge funds.2 For some companies, “cushion” provided by the second lien this deeper level of market interest can debt may make the remaining first lien make the difference between being able debt easier to syndicate. In addition, the to do a deal and not having access to first lien creditors can protect their

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interests through a lien subordination in the first place. We will then discuss agreement that strips the second lien which of these rights second lien creditors of most of the secured creditor bondholders and second lien lenders rights they might otherwise exercise to may be willing to part with. the detriment of the first lien creditors. This leaves the second lien creditors What is the Difference Between with a “silent second” lien. Debt Subordination and Lien Subordination? Why Would a Junior Creditor Basics. In traditional contractual be Willing to Accept a “Silent subordination, the debt claim itself is Second” Lien? subordinated. If a subordinated debt Even a “silent second” gives a second holder obtains anything of value in a lien creditor effective priority over trade bankruptcy from any source, it agrees to creditors and other unsecured creditors, turn it over to the holders of “senior up to the value of its interest in the debt” until the senior debt is paid in collateral. In terms of payment priority, full. In lien subordination, the liens are “silent second” status does not affect subordinated; the underlying debt claim the value of being secured—a second is not. What this means is that the lien creditor is always better off in this holder of second lien debt only agrees regard than it would be if it were to turn over proceeds from sales of unsecured. In addition, under the lien shared collateral to the holders of first subordination agreement in most deals, lien debt. The holder of a second lien the second lien creditors expressly secured claim does not have to turn over reserve all of the rights of an unsecured funds to the holders of first lien debt creditor, subject to some important distributed to it from other sources. exceptions. Priority vis-à-vis the trade. In its simplest terms, debt subordination places the Some Important Background subordinated debt behind the senior Information debt, but does not place it ahead of any other debt of the borrower (unless So far, we have established that second holders of that other debt agree, in turn, lien debt holders get paid second when to subordinate their debt to the it comes to proceeds of collateral. We subordinated debt). By contrast, have also said that second liens are, at although lien subordination does place least typically, “silent seconds.” So the second lien debt behind the first lien where’s the controversy? Well, the key debt to the extent of the value of the question is “How silent is silent?” Some first lien creditor’s interest in the market participants are from the old collateral, it also places the second lien school of senior lending. These players debt ahead of the trade and other believe that second lien debt holders unsecured creditors, to the extent of the should only speak when they are value of its interest in the collateral. spoken to. Others would characterize This is the key benefit for the second “silent second” lien financings as “quiet lien creditors. seconds.” These players are willing to defer to first lien holders up to a point or Anti-layering covenant issues. A typical 3 for a limited period of time, but no more. “anti-layering” covenant will prohibit All the action in the structuring and an issuer from incurring new debt that negotiating of second lien deals revolves is subordinated “in right of payment” around the determination of how silent unless that new debt is also is “silent.” In order to address that subordinated to (or pari passu with) the critical question, we need to explore debt containing the anti-layering some background information about provision. However, a typical anti- what it means to be a secured creditor layering covenant does not restrict the incurrence of second lien debt because

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it isn’t subordinated “in right of residual $100 claim will be treated as a payment.”4 general unsecured claim. As a result, an “undersecured” creditor will hold both Payment blockage issues. Unlike secured and unsecured claims. Under traditional subordinated debt, second the bankruptcy code, secured claims are lien debt is not typically subject to entitled to receive value equal to the full payment blockage provisions of any kind. value of their interest in the collateral Remedy standstill provisions. The before any value is given to holders of remedy bars in second lien deals unsecured claims, and any priority typically only apply to remedies unsecured claims are entitled to receive associated with the collateral. Most the full value of their claims before any second lien deals specifically preserve general unsecured claims receive any all or almost all of the remedies that value. To the extent a secured creditor is would be available to an unsecured “undersecured” (i.e., the value of its creditor, with a few exceptions (as we collateral is less than the amount of its will discuss below). In the case of bond pre-petition claim) that undersecured deals issued in public offerings (or in creditor will share pro rata with other private placements with registration general unsecured creditors (including rights), the Trust Indenture Act prohibits trade creditors) in the amount, if any, any bar on actions to collect payments remaining after repayment in full of due and owing to bondholders, but it both secured claims and priority does allow limits on enforcement actions unsecured claims. against collateral. Post-petition interest. A secured creditor is entitled to post-petition interest under In a Bankruptcy, What Rights do the bankruptcy code to the extent the Secured Creditors Gain? value of its interest in the collateral In a bankruptcy proceeding, secured securing its claim is greater than the creditors have a variety of meaningful amount of its pre-bankruptcy claim. An rights that unsecured creditors don’t undersecured creditor is not entitled to have. As a result, secured creditors post-petition interest. As a result, in the enjoy significantly higher recovery rates example discussed above, the first lien in bankruptcies and other reorganizations creditor’s $50 secured claim will than unsecured creditors. increase during the pendency of the Priority vis-à-vis the trade and other bankruptcy proceeding to the extent of unsecured creditors. Under the any accrued interest that is not paid bankruptcy code, creditors’ claims can currently, thereby reducing the likely generally be divided into three basic recovery by the second lien creditor. classes: (1) secured claims, (2) priority Adequate protection rights. Under the unsecured claims, and (3) general bankruptcy code, a secured creditor has unsecured claims.5 A second lien the right to be protected against creditor’s claim is treated as a secured declines in the value of its interest in the claim to the extent of the value of its collateral following the date of the interest in the collateral. For example, bankruptcy filing. This is a very broad assume the company in bankruptcy right and entitles a secured creditor to a owes $50 to a first lien creditor and $200 voice in any actions taken in a to a second lien creditor and that both bankruptcy proceeding that could affect the first and second lien debt are the value of its collateral (including the secured solely by liens on an asset use of cash collateral, sales of collateral, worth $150. In this case, the first lien substitutions of collateral or the grant of creditor will have a $50 secured claim a priming lien on collateral to secure a and no unsecured claim. The second DIP financing). Upon request, secured lien creditor, in turn, will have a secured creditors are entitled to assurance that claim of $100. The second lien creditor’s their collateral is adequately protected if

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there is a serious risk of its diminution in prior or equal liens. As a result, creditors value. The “adequate protection” may secured by all or substantially all of the take the form of a court-ordered grant of bankrupt company’s assets will have a additional or substitute collateral or the strong say over the company’s ability to provision of periodic cash payments to obtain a priming DIP loan. the secured creditor. The bankruptcy Harder to be “crammed down.” In a court has broad discretion in fashioning bankruptcy, the creditors in each class an appropriate remedy in this regard. have the right to vote on any proposed Right to object to use of cash collateral. plan of reorganization. However, in “Cash collateral” is a defined term in certain circumstances, a plan of the bankruptcy code and includes cash, reorganization can be confirmed over negotiable instruments, securities, the objections of a particular class of deposit accounts and other cash creditors. A class of creditors that is equivalents in which a pre-petition forced to accept the terms of a plan that creditor has a security interest. Under it voted against is said to be “crammed the bankruptcy code, a company in down.” It is generally much harder for a bankruptcy is not permitted to use cash class of secured creditors to be collateral unless each creditor that has a “crammed down” in a bankruptcy than security interest in the cash collateral a class of unsecured creditors. Under the consents to its use or the bankruptcy bankruptcy code, a class of creditors can court authorizes its use, after notice and only be crammed if the plan of a hearing. This gives each secured reorganization is “fair and equitable” to creditor a say on the use of cash that class. The standard for what is fair collateral, unless the bankruptcy court and equitable is higher for secured orders otherwise. creditors than it is for unsecured creditors, which gives secured creditors Right to approve asset sales. Under the greater leverage at the bargaining table bankruptcy code, a company in in bankruptcy plan negotiations. bankruptcy can sell assets, free and clear of all liens, in various More leverage in plan negotiations. The circumstances. However, under certain combined effect of these various circumstances, the consent of a secured secured creditor rights is to give secured creditor to a sale of its collateral may be creditors far more leverage than required. If more than one party has a unsecured creditors in negotiating and lien on the collateral, each of the shaping the plan of reorganization. secured creditors may be required to consent to the sale. What Rights do Unsecured Creditors Right to approve secured DIP Have Outside of Bankruptcy? financings. A company in bankruptcy Unsecured creditors (as well as secured needs funds to operate. For obvious creditors) have several important rights reasons, many bankrupt companies outside of bankruptcy, including: have negative or marginal cash flow, • the right of any three unsecured or which prompts the need for “debtor-in- undersecured creditors to put a possession” or “DIP” financing company into an involuntary arrangements. DIP financings can be bankruptcy;6 secured or unsecured, but are generally • the right to accelerate their debt and secured on a first priority basis. The sue for payment; and bankruptcy code authorizes the • the right to challenge the validity, bankruptcy court to provide for a DIP enforceability or priority of any liens loan to be secured by a lien that is on the company’s assets. senior or equal to the liens held by the other secured creditors, as long as those As a result, unsecured creditors need to other secured creditors are given be reckoned with and will be “at the adequate protection or consent to the table” in any out-of-court restructuring

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process if they are not being paid and other applicable laws is that either current interest. creditor has the right to foreclose on the asset. If the first lien creditor forecloses What Rights do Unsecured on the asset, the second lien creditor is Creditors Have in a Bankruptcy? not entitled to any of the foreclosure proceeds until the first lien creditor has Unsecured creditors (as well as secured received the full value of its claim. If the creditors) have other meaningful rights second lien creditor forecloses on the during a bankruptcy, including: asset, the first lien remains in place on • to request the appointment of a the sold asset and the second lien trustee in bankruptcy (e.g., because creditor is entitled to the foreclosure the bankrupt company is proceeds. However, as a practical mismanaging the business); matter, few buyers in a foreclosure sale • to propose a plan of reorganization at are willing to buy an asset subject to a the end of the 180-day (or longer) first lien, and few first lien creditors are time-period in which the bankrupt willing to release their first liens unless company has the exclusive right to their debt has been repaid in full. As a propose a plan; result, it is common for the agreements • to vote on a plan of reorganization; between creditors to provide that the • to challenge the validity, first lien creditors have the right to enforceability or priority of any liens control the disposition of collateral on the bankrupt company’s assets; and (possibly subject to time or other • to challenge or dispute any other limitations). actions taken or not taken, or any Restrictions on dispositions of collateral. motions made, by the bankrupt A secured creditor does not have an company, any secured creditor or any unfettered right to dispose of collateral. other interested party. The interests of the debtor and other Although, generally, the rights of an secured creditors are protected by a unsecured creditor in bankruptcy are variety of rules designed to protect the significantly less than those of a secured interests of the debtor and other secured creditor, they are enough to give creditors in the value of the collateral, if unsecured creditors a “seat at the table” any, remaining after repayment in full of in the plan negotiations. the claims of the secured creditor that forecloses on the collateral. Most of What are the Relationships these rules can’t be waived by a debtor Between Multiple Secured or other pledgor or may only be waived Creditors at Law (i.e., Absent an by a debtor or other pledgor under an Intercreditor Agreement)? agreement entered into after a default has occurred. In addition, in certain Order of priority. The general rule is cases, particularly where the first lien first-in-time, first-in-line. Under that creditor has agreed to serve as agent for general rule, as between two secured the second lien creditor, a first lien creditors, unless otherwise agreed by creditor may owe fiduciary duties8 to the those creditors, the first to “perfect” its second lien creditor. These rules security interest in an asset gets the first effectively limit the ability of a secured priority lien on that asset. The second in creditor to conduct collateral “fire sales.” time is second in line.7 Priority is important because it determines the Rules governing foreclosure on UCC order of repayment when the collateral collateral. The UCC contains a variety of is sold or otherwise disposed of. substantive and procedural requirements governing foreclosure on personal Control over enforcement actions. If two property collateral that is subject to the creditors are secured by liens on a UCC.9 Most important, under the UCC, particular asset, the general rule under every aspect of a disposition of collateral the Uniform Commercial Code, or UCC,

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must be “commercially reasonable.” A be disposed of in haste at significantly secured party is liable to the debtor and below its fair market value. other parties with a security interest in Bankruptcy code restrictions. The the same collateral if it fails to comply bankruptcy code also imposes its own with this standard or if it fails to comply set of restrictions on asset sales. During with any of the notice or other a bankruptcy, with limited exceptions, a requirements surrounding foreclosure secured creditor generally does not have imposed by the UCC. These UCC a right to compel sales of collateral. As requirements also effectively limit the a general matter, the company in ability of any secured creditor to sell bankruptcy decides which assets to sell collateral at a “fire sale.” (albeit, in practice, following discussions Rules governing foreclosure on real with its secured creditors). Asset sales property collateral. The substantive and are governed by Section 363 of the procedural requirements that govern bankruptcy code. These “363 sales,” as foreclosure of real property collateral they are commonly known, are subject vary from state to state. In most states, a to overbidding and bankruptcy court secured creditor can foreclose on real scrutiny and approval, with a view to property through a judicial foreclosure, achieving the best available sale price. supervised by a state court. In some states, a secured creditor can also Structuring Questions enforce remedies against real property outside of the court system through a With that background discussion behind non-judicial foreclosure in which a us, we will now turn to a series of trustee or referee conducts the sale. If specific questions about how to the sale is conducted through a judicial structure a second lien financing. foreclosure, the secured party will typically have to satisfy procedural What Makes a “Silent Second” requirements intended to ensure that Silent? the sale is conducted in a public forum A lien only becomes “silent” if the to protect against a sale of the real holder of the lien agrees not to exercise property below fair market value. some or all of the special rights that it Fiduciary duties in the “zone of obtained by becoming a secured insolvency.” Directors and officers of a creditor. The terms of the “silent company owe a fiduciary duty to the second” are usually set out in an company’s shareholders to act in what agreement entered into by the they reasonably believe to be the best representatives of the various classes of interests of the shareholders. However, creditors (typically a collateral trust if the company enters the “zone of agreement or an intercreditor insolvency,” those fiduciary duties are agreement). Second lien bond deals additionally, and primarily, owed to the tend to be more “silent” than second company’s secured and unsecured lien term loan deals. However, creditors. A company in bankruptcy customary “silent second” lien clearly falls within the zone of subordination agreements in both the insolvency. However, a company can bond and term loan markets have four also be in the zone of insolvency as it primary elements: approaches bankruptcy. As a rule of • prohibitions (or limitations) on the thumb, a company is in the zone of right of the second lien holders to insolvency if it can’t generally pay its take enforcement actions, with debts as they become due or if the fair respect to their liens (possibly subject market value of its assets is less than the to time or other limitations); fair market value of its liabilities. These • agreements by the holders of second fiduciary duties to creditors are a further liens not to challenge enforcement or limit on the likelihood that collateral will foreclosure actions taken by the

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holders of the first liens (possibly period of time is often referred to as a subject to time or other limitations); “fish-or-cut-bait” or “standstill” period. • prohibitions on the right of the second At the end of the standstill period, the lien holders to challenge the validity first lien lenders lose their monopoly on or priority of the first liens; and the exercise of secured creditor • waivers of (or limitations on) other remedies. In a small number of deals, if secured creditor rights by the holders the first lien lenders have not taken of second liens. steps to exercise remedies against the collateral when the standstill period expires, they forfeit any further right to What Secured Creditor Rights take remedies, giving the second lien do the Second Lien Debt Holders lenders the monopoly on remedies. Typically Waive During the Period There are many variations on the scope Before a Bankruptcy Filing? and duration of these temporary The answer to this question depends on standstill arrangements. the context. In a second lien bond deal, the second lien creditors tend to be truly Both second lien term lenders and “silent.” This means that the first lien second lien bondholders typically waive lenders generally control all decisions their right to challenge the validity, regarding the enforcement of remedies enforceability or priority of the first against the collateral as long as any first liens.10 lien debt is outstanding. As a result, following a default on the first lien debt, What Secured Creditor Rights do subject to the UCC, bankruptcy code the Second Lien Debt Holders and other legal limitations discussed Typically Waive in a Bankruptcy? above, the first lien lenders typically The short answer is all of the same decide, among other things: rights they waive before bankruptcy • whether and when to exercise (see above), plus some others. The remedies against the collateral; longer answer depends, again, on the • which items of collateral to proceed context. The post-bankruptcy waivers against and in which order; tend to be broader in second lien bond • whether the sale should be a public deals than in second lien term loan or a private sale; and deals. We think this will likely continue • to whom collateral should be sold and to be the case as investors in the term at what price. loan market tend to have a stronger desire to participate in plan negotiations However, the answer to this question than buyers of bonds in Rule 144A can change dramatically if the total financings. Bond buyers are typically amount of the second lien bond debt more focused on getting priority over significantly exceeds the amount of the trade creditors than on retaining any first lien debt. If there is significantly particular rights in a bankruptcy case. more second lien bond debt in the The following waivers and consents are capital structure than first lien bank commonly seen in lien subordination debt, the bonds may expect to have an agreements in both the bond and term active (and possibly even controlling) loan markets: voice in the exercise of remedies under the security agreements. • adequate protection waivers; • advance consents to use of cash By contrast, in a second lien term loan collateral; deal, the second lien is often more in the • advance consents to sales of nature of a “quiet second.” Generally, collateral; and second lien lenders will only agree to • advance consents to DIP financings. refrain from exercising their secured creditor rights for a limited period of Waiver of the right to seek “adequate time, typically 90 to 180 days. This protection.” First, let’s look at the bond

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market. It is currently typical for second bonds waive these rights. However, in lien bondholders to waive their right to many cases, there is strong resistance by claim adequate protection on their own some participants in the institutional behalf until the first lien debt has been term loan market to agree to any paid off, with some limitations. adequate protection waivers. It is However, second lien bondholders will unclear at this point where the second typically (and should) reserve their lien loan market will settle on this adequate protection rights to ask for a important issue. junior lien on any property on which the The practical significance of these bankruptcy court grants a lien to secure adequate protection waivers depends on first lien debt, as long as the new junior the facts of the case. Excluding the lien is subject to the same lien ability to have a say in the use of cash subordination arrangements as the collateral and DIP financings (which we original second lien. This right is critical will discuss below), the principal benefit to avoid erosion of the second lien of adequate protection is the right of a bondholders’ bargained—for collateral. secured creditor to ask for additional or Most security agreements contain an substitute collateral to protect against “after-acquired collateral“ clause that declines in the value of the collateral grants the secured creditor a lien on all after the date on which the bankruptcy then-owned collateral and on any commenced. This right is of critical collateral acquired in the future. importance to a holder of liens on “quick However, under the bankruptcy code, assets” (as discussed above), and it is also liens created prior to a bankruptcy meaningful if the company in bankruptcy generally do not attach, or apply, to has valuable unencumbered, or partially assets acquired or arising after the encumbered, assets on which additional commencement of the bankruptcy or replacement liens can be granted to proceeding. As a result, it is customary protect the value of the original liens. for secured creditors to agree to permit The remedy is of more limited utility to uses of the cash proceeds from sales of a second lien creditor that already has a their collateral consisting of inventory, lien on all of the borrower’s assets. accounts or other similar classes of “quick assets” only if the court permits In most cases, the borrower will have them to obtain a lien on “quick assets” some unencumbered assets and the created or acquired after the grant of a lien on those assets to commencement of the bankruptcy. In compensate for deterioration in the general, the first lien lenders can be value of the second lienholder’s original counted on to make this request collateral may materially enhance the (typically phrased as an adequate second lien creditors’ ultimate recovery. protection motion). However, the second The value of the second lien creditors’ lien creditors need to be able to tag interest in any additional or substitute along in order to preserve their second collateral obtained to secure second lien liens on “quick assets” acquired after obligations increases, dollar for dollar, the commencement of the bankruptcy or the amount of the secured claims held they will lose the benefit of their by the second lien creditors. As a result, bargain. giving up the opportunity to obtain additional or substitute collateral in the The market is less settled for second name of adequate protection could have lien term loans. In some cases, real-world cost. On balance, however, if particularly where there are second lien the second lien creditors preserve their term loans and pari passu second lien right to obtain a second lien on any new bonds with similar (or even identical) collateral provided to the first lien covenants, the term loans will waive creditors in the name of adequate their adequate protection rights for so protection, their waiver of the right to long as any first lien debt is outstanding seek other forms of adequate protection in the same way that the pari passu

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on their own will not prove to be an lien debt. By providing an advance imprudent concession in most real-world consent to asset sales, the second lien circumstances. debt no longer has any say as to sales of collateral approved by the first lien Waiver of the right to oppose “adequate debt. If the second lien debt is protection” for the first lien debt. Both undersecured, it may be relying on a second lien term lenders and second successful reorganization of the debtor lien bondholders typically waive any for repayment of its debt. The first lien right to dispute actions taken by the first debt, on the other hand, is much more lien lenders to seek adequate protection likely to be oversecured and will often with respect to the collateral securing want a quick liquidation of the bankrupt the first lien debt. This waiver is not company’s assets, without regard to the particularly controversial and is not company’s prospects of emerging from usually subject to any time limitation. bankruptcy. This opens the door to the Advance consent to the use of cash possibility for mischief, such as a fire collateral. Both second lien term lenders sale of assets at below fair market value and second lien bondholders typically or a sale of key income-generating give an advance consent to any use of assets or other material assets whose cash collateral approved by the first lien sale might eliminate the possibility of a debt (effectively waiving their right to successful reorganization. However, oppose the company’s proposed use of there are other protections for the cash collateral on adequate protection second lien creditors—the sale still has grounds). The primary benefit to a to be approved by the bankruptcy court secured creditor of an approval right and must be conducted through an over the use of cash collateral is that it auction process, at which the second allows the secured creditor to put a lien creditors can bid,12 and the fiduciary brake on the company’s activities (and duties and other legal requirements thereby force a liquidation), since a discussed above should prevent most of company in bankruptcy invariably the potential for mischief from ever cannot operate without access to cash coming to fruition. and other cash collateral. Secured Advance consent to DIP financing creditors can, and frequently do, approved by the first lien debt. Second condition access to these funds on lien term lenders and second lien adoption by the company in bankruptcy bondholders typically agree to some of a satisfactory operating budget. As a form of advance consent to DIP result of this advance consent, the financings. This advance consent second lien debt will almost certainly be appears in various permutations: required to rely on the first lien creditors to handle these budget negotiations.11 • unconditional consent to any DIP financing approved by the first lien Advance consent to sales of collateral. creditors, with no cap on the amount Both second lien term lenders and of the DIP financing; second lien bondholders typically agree • conditional consent to any DIP not to object to any court-approved financing approved by the first lien asset sale that is also approved by the creditors, subject to a dollar cap first lien lenders as long as the second (which typically includes a cushion to liens attach to the proceeds of the sale allow “protective advances”) on the in accordance with the lien priorities amount of the DIP financing; and agreed to in the lien subordination • conditional consent to any DIP agreement. Second lien term lenders financing approved by the first lien (but generally not second lien creditors, but only if the liens bondholders) may additionally condition securing the DIP financing rank prior their advance consent on the use of all or equal to the liens securing the first or a specified portion of the sale lien debt. proceeds to permanently reduce the first

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The third permutation is becoming compliance with every aspect of the increasingly popular. It is attractive to advance waivers and consents contained second lien creditors because it requires in a lien subordination agreement, but the first lien creditors to “share the the final plan of reorganization will likely pain” and thereby reduces the chances give effect to the agreement’s priority of an overly-generous DIP, and it is waterfall provisions by treating first and acceptable to first lien creditors and second lien creditors as separate classes borrowers because it does not for plan purposes.13 As a court of equity, arbitrarily cap the amount of the DIP a bankruptcy court may well allow the financing. This permutation is generally second lien creditors to assert rights they a reasonable and fair compromise from agreed to waive in the lien subordination the perspective of all parties involved. agreement, leaving the first lien creditors to sue the second lien creditors in state Is There a Preferred Way to court for breach of contract damages. In Document These Lien practice, that course will not likely be Subordination Agreements? appealing to the first lien creditors absent repeated and flagrant disregard of the Some deals reflect the lien subordination original bargain by the second lien terms in a collateral trust agreement, creditors. while others use an intercreditor agreement. Substantively, the choice of document is a distinction without a Does a “Silent Second” Lien difference—it doesn’t affect the terms of Creditor Ever End up Worse Off the subordination agreements Than an Unsecured Creditor? themselves. Typically, the parties will Typically, a lien subordination use a collateral trust agreement if an agreement expressly states that, both independent collateral trustee holds the before and during a bankruptcy, the first and second liens for the benefit of second lien creditors can take any both the first and second lien debt. Most actions and exercise any rights that they of the larger second lien bond deals would have had if they were unsecured have employed an independent creditors, except any rights they collateral trustee. Conversely, where the expressly waived in the lien parties prefer to have separate entities subordination agreement, such as with hold the first and second liens, the respect to adequate protection, use of subordination provisions are usually cash collateral, sales of collateral, DIP documented in an intercreditor financings and the right to challenge the agreement. This latter method is more first liens.14 We think these limitations common in the term loan market. are appropriate. We have seen first lien creditors go even further, however, and Are Lien Subordination request advance agreements by the Agreements Enforceable? second lien bondholders on how they will vote on a plan of reorganization. Courts are generally willing to enforce These voting agreements generally lien subordination agreements between come in two basic forms: (1) an a company’s creditors, even where the agreement not to support or vote in company is in bankruptcy. The favor of a plan, unless the first lien bankruptcy code specifically says that a creditors vote in favor of the plan or the subordination agreement is as plan meets certain conditions (e.g., that enforceable in a bankruptcy as it is the first lien debt gets repaid in full), outside of bankruptcy. As a general and (2) an agreement not to oppose a matter, a lien subordination agreement plan supported by the first lien creditors. containing the types of provisions These voting agreements are more discussed above should be enforceable controversial and may not be enforceable. under state law, both before and during a bankruptcy. In practice, most The right to vote on a plan of bankruptcy courts will not monitor reorganization provides significant 11 Number 382 | April 15, 2004 Latham & Watkins | Client Alert

protections for a secured creditor. First won’t agree to allow the first lien debt to and second lien creditors have very control the release of any of their different interests and they frequently collateral. We have generally observed (and often strongly) disagree on the second lien term loans agreeing to allow merits of a proposed plan. Furthermore, releases of their collateral by an act of unsecured creditors almost never agree the first lien creditors only in deals to limit their voting rights in a plan and where the second lien term loans are including such a provision in a lien pari passu with a tranche of high yield subordination agreement could cause bonds being marketed concurrently that the “silent second” lien creditor to have contains a similar provision. significantly less bargaining power than an unsecured creditor in plan Who Controls Releases of negotiations. These factors may explain Collateral During a Bankruptcy? why restrictions on the right to vote for During a bankruptcy, the market or against particular plans of standard seems clear. The second lien reorganization are relatively rarely holders, whether bondholders or term agreed to by second lien bondholders loan providers, typically agree not to and almost never agreed to by second object to any court-ordered asset sale lien term loan lenders. approved by the first lien creditors as long as the second liens attach to the Who Controls Releases of proceeds of the sale in accordance with Collateral Outside of Bankruptcy? the lien priorities agreed to in the lien Generally, the second lien documents subordination agreement. provide for an automatic release of the second liens on any collateral upon a Do Second Lien Holders Get the sale of that collateral, possibly subject to Same Collateral as First Lien the requirements of an agreed “asset Holders? sale” covenant.15 There is less consensus Generally, the first lien debt will hold a as to who controls releases of collateral “blanket lien” on all assets of the outside of the sale context. In the high borrower and the guarantors, with very yield bond market, we believe there are limited exceptions. The exceptions will three broad approaches to this issue: typically involve situations where the • In some bond deals, the first lien first lien lenders conclude that the cost creditors can release any or all of the and effort of obtaining a particular lien collateral on behalf of both first and outweighs the benefit of that lien to the second lien creditors at any time. first lien lenders, or the borrower is • In other deals, releases of collateral unable to obtain contractually-required from the second liens are only third party consents to the grant of the allowed if permitted under the first liens.16 documents governing both the first In general, the second lien collateral and second lien debt. will not include any assets excluded • In still other deals, the first lien from the first lien collateral. The second creditors can release collateral on lien creditors will generally expect to behalf of both the first and second have a lien on all of the assets securing lien creditors, unless it involves “all or the first lien debt. However, depending substantially all” of the collateral, in on the type of debt making up the which case, both the first and second second lien debt, certain categories of lien debt must approve the release. assets may be excluded from the second This last approach is the middle ground lien collateral. If the second lien debt and is where we expect the second lien consists solely of term loans, there will bond market to settle. Holders of second tend to be very few (if any) differences lien loans, on the other hand, have a between the collateral securing the first different perspective, and generally lien debt and the collateral securing the

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second lien term loans. However, if the creditors control over the “on/off” second lien debt consists of or includes switch for both the first and second registered bonds or bonds sold with liens. In an exemptive order granted by registration rights, there may be the SEC in 2001, the SEC determined important differences between the first that the Section 314(d) requirements do lien and second lien collateral packages not apply at all if a third party (such as for the legal and practical reasons another group of secured creditors) discussed below. controls the release of the collateral.18 This latter approach is favored by What are the Legal Issues Limiting issuers who do not want the the Scope of the Collateral Package administrative burden of producing in Second Lien Bond Deals? independent engineer’s opinions under any circumstances and seems a fair There are two sets of restrictions that resolution of the debate on who controls apply only to registered bonds or bonds lien releases as long as less than all or that are subject to registration rights. substantially all of the collateral is First, Section 3-16 of Regulation S-X involved. The state of the current law is under the Securities Act makes it very less than entirely clear, however, and difficult to give bondholders a lien on we think the SEC should make clear stock (or intercompany notes) of that the burdensome requirements of subsidiaries. That section requires an Section 314(d) are not intended to apply annual audit of each subsidiary whose to any releases of collateral provided for stock (or intercompany notes) is pledged in the original indenture. if the value of the stock (or notes) exceeds 20 percent of the face amount What are the Practical of the secured bonds.17 Considerations Limiting the Scope Second, the Trust Indenture Act applies of Second Lien Note Collateral? to debt securities issued under an If the borrower persuades the first lien indenture in a registered offering (or debt at a future date to release part of subsequently registered pursuant to a its collateral (because the credit has registration rights agreement). Section improved or for some other reason), the 314(d) of the Trust Indenture Act includes first lien debt will almost certainly various certification and opinion condition its lien release on the second requirements that must be satisfied prior lien debt not having a lien on the to the release of collateral securing collateral to be released. In a deal notes issued under a public indenture. where the first lien creditors do not have Generally, those certifications and authority to release liens on behalf of opinions can be made by an officer of both first and second lienholders, the the issuer. However, subject to limited borrower will want to avoid the need for exceptions, if the value of the collateral a second lien bondholder consent to be released is 10 percent or more of (which may involve an expensive and the amount of the notes then outstanding cumbersome consent solicitation) every under the indenture, those certifications time it wants collateral released. As a and opinions must be provided by an result, second lien bondholders have independent engineer, appraiser or often been persuaded to accept a more other independent expert. limited collateral package than the first In most cases, no certificates or opinions lienholders. In particular, it is not will be required for releases of collateral uncommon for bondholders to forego in the ordinary course of business, liens on immaterial parcels of owned although the SEC orders granting the and/or leased real property and to ordinary course exemptions are not as provide for a general exclusion for sweeping as might be expected. personal property in which a security Another way out of the Section 314(d) interest can’t be perfected by the filing requirements is to give the first lien of a UCC financing statement (up to

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some agreed cap).19 This general As a general rule, Permitted Prior Liens “basket” is typically capped at a fixed fall into four categories: dollar amount, although, in some cases, • liens securing the first lien debt (and it is a percentage of asset value. all related “obligations”); • liens that pre-date the second liens Are There any Limits on the (which, in some deals, may include Amount of Future First Lien Debt? liens that the borrower “inherits” if, Yes. In order to protect the second lien for example, it acquires assets in the creditors from losing the value of their future that are subject to liens); accrued claims, the typical covenant • liens securing a specified amount of package in a second lien deal will fix the purchase money debt; and maximum principal amount of first lien • liens that are not voluntarily granted debt that may be incurred. The cap is by the borrower but arise by operation typically fixed at a specified dollar amount of law and are entitled by law to (which typically includes a cushion to priority over the second liens (for allow “protective advances”), but may example, certain tax and ERISA liens). sometimes be a function of a maximum Not every one of these categories is leverage ratio or other financial test. appropriate in every deal. The exact definition of “Permitted Prior Liens” will Are There any Limits on the Amount need to be negotiated appropriately to of Future Second Lien Debt? suit the context in each deal. The Yes. In order to protect the second lien obligations secured by Permitted Prior creditors from being diluted, the typical Liens can be material and may affect the second lien covenant package will cap successful marketing of the transaction. the borrower’s ability to incur additional second lien debt. The cap is usually Can the Second Lien Creditors based on a maximum leverage ratio or Purchase the First Lien Obligations? other financial test although it could be In some second lien financings, the first expressed as a dollar cap. lien creditors have given second lien bondholders and second lien lenders an Are there other “Permitted option to purchase the first lien Prior Liens”? obligations. The exercise price is The phrase “second lien debt” is a generally the par value of the shorthand statement of the relative outstanding first lien debt plus accrued priorities of the liens securing first and interest (excluding any amounts payable second lien debt. It is not an absolute as prepayment or acceleration penalties statement of the priority of the liens or premiums). Usually, the option can be securing second lien debt. In reality, the exercised during an agreed time period liens securing second lien debt are starting on the date on which the junior both to the liens securing the first company files for bankruptcy and/or the lien debt and certain other liens, usually first lien creditors take any action to called “Permitted Prior Liens,” which foreclose on their collateral. Some are permitted to rank ahead of the second lien lenders and, less often, second liens (and possibly the first liens) some second lien bondholders view the under the terms of the security purchase option as a “must-have” documents. The payment of creditors provision. First lien creditors generally secured by Permitted Prior Liens will view the purchase option as acceptable generally be baked right into the since, if exercised, it allows them to exit priority waterfall provisions for a troubled credit at par. distributions of collateral sale proceeds The purchase option has some value for contained in the lien subordination the second lien creditors because, once agreement. it is exercised, the second lien creditors

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will no longer be subject to any of the whether the first and second liens can lien subordination arrangements be granted in a single set of security discussed above and will be free to documents (containing separate grants exercise all of the rights of a secured of security interests for the first and creditor. As a result, the second lien second liens) rather than in separate creditors will have increased leverage in sets of security documents. Some first the plan or out-of-court restructuring lien lenders are concerned that they negotiations that may translate into a may prejudice their right to post-petition higher net recovery for the second lien interest unless the first and second liens creditors. However, in any restructuring have completely separate security where the second lien creditors are documents. We believe that, if properly sufficiently organized and able and documented, a single set of security willing to buy out the first lien position at documents should work to ensure that par, an amicable arrangement will likely the first and second lien creditors hold be within easy reach. As a result, many separate secured claims. Each security market participants do not attribute document should contain two separate significant value to including this option granting clauses and a clear statement in the original documentation. of an intention to create two separate classes of secured creditors. Do We Need a Separate Collateral Trustee to Hold the Collateral? How Do Various Classes of In most large second lien bond deals, Creditors Vote? the first and second liens run to, and As we have discussed above, generally any possessory collateral is held by, a the first lien creditors control (at least for single independent collateral trustee for some period of time) many of the key the benefit of the holders of the first and decisions relating to the collateral. second lien debt. In those deals, the lien Typically, in both second lien bond deals priority and subordination provisions are and second lien term loan deals, the contained in the collateral trust collateral trustee(s) are only authorized agreement. That agreement will also to take action if instructed to do so by typically provide for the possibility of first lien lenders holding more than 50 future first and second lien financings percent of the total amount of the without a need to amend the outstanding first lien debt. Often, the documentation. In other bond deals and amount of unfunded commitments is not in second lien term loan deals, by counted for voting purposes in contrast, the practice is generally for connection with the exercise of each of the first and second lien debt remedies on the theory that only the holders to have separate collateral holders of funded first lien debt have agents. The first and second liens are “skin in the game.” granted to the respective collateral If there is more than one series of first agents, and the first lien collateral agent lien debt outstanding, the first lien will hold any possessory collateral for creditors need to decide among the benefit of both the first and second themselves on how the various series of lien holders. The lien priority and first lien debt will vote together as a subordination arrangements are single class. There are two general governed by an intercreditor agreement approaches to this conundrum. The first signed by the collateral agents for the is the electoral college system, under first and second lien debt. which each series of debt within a class votes as a block in favor of (or against) Do We Need Two Sets of the proposed action. The block vote of Security Documents? each series is determined by a majority Because of a single unfortunate case (or supermajority) of the holders in that from 1991,20 there is some debate as to particular series. The second approach

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is the popular vote system, in which all structuring points that find their way of the debt in a class (regardless of into the lien subordination agreements series) votes together as a single class. that define the rights of second lien The popular vote system tends to be less creditors in these deals, but we have not attractive because it does not address yet reached a market equilibrium on the situation where different series of every point. High yield bondholders debt have different voting requirements have tended to be more accommodating to approve a particular action. One than many term loan lenders, but much series of debt may require majority depends on the context of the particular approval for a particular action, while deal and generalizations are rarely another series of debt may require conclusive. We have included a chart at supermajority approval for the same the end of this client alert that attempts action. By lumping all the series of debt to capture our view of “the market” as into a single voting group, the voting of the Spring of 2004 for your requirements for the various series of convenience. However, we fully expect debt may be effectively replaced with a the market consensus to evolve over single uniform voting standard that is time and you should expect that too. not consistent with the parties’ If you have any questions about second bargained for intent. lien financings or this client alert, please feel free to call Neil Cummings, at Summary (213) 891-8485, Kirk A. Davenport, at Second lien financing structures are (212) 906-1284, Marc P. Hanrahan, at here to stay. These financings can (212) 906-2976, or Peter M. Gilhuly, at provide some below-investment-grade (213) 891-8720 or any of the other companies with access to the capital Latham lawyers named on the back of markets where they would otherwise this client alert. not have access at all. Other high yield Endnotes issuers are able to obtain financing on 1 Term loan B’s are a variation on the type of more favorable terms by granting term loans (which are now often called term collateral to their junior creditors. loan A’s) traditionally made by banks and However, there can be costs associated other financial institutions that want both a with second lien financing structures, steady return of principal (through periodic and a careful borrower will want to amortization) and interest payments. Term think through the consequences of loan B’s are targeted at, and typically held by, issuing second lien paper on its ability hedge funds and other institutional investors to tap the debt markets in the future. with a longer term investment strategy. As a result, term loan B lenders generally require Traditional first lien lenders are not only nominal, if any, principal repayment on predisposed to favor second lien deals, their term loan B’s until the maturity date (or but they have been required to take a the year prior to maturity), and have the right more flexible approach to these new to refuse all or a specified portion of optional financing structures to help reduce their prepayments made by the borrower. If both a term loan A and term loan B are made to the own exposure or to accommodate borrower in the same transaction, the interest borrower clients desiring to raise capital rate on the term loan B generally will be in this new way. We do not expect first higher than on the term loan A. If a credit lien lenders to ever be vocal advocates facility contains both a term loan A and term for securing the claims of their junior loan B, any optional prepayment amounts not cousins in the capital structure, but they applied to prepay the term loan B typically can no longer simply ignore these new will be applied to prepay the term loan A. products. Term loan B’s bear interest at a floating rate (typically), sometimes with specified mini- Second lien bondholders and second mum rates, and have covenant packages that lien term lenders are inching their way are derived from (and substantially similar to) toward consensus on many of the key those found either in the borrower’s traditional

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bank credit agreement or, in an increasing their claims against the company is at least number of cases, in the borrower’s high yield $11,625 more than the total value of their bond indenture. interests in assets of the company pledged to 2 secure those claims. CBOs, CDOs and CLOs are structured vehicles 7 that issue asset-backed securities, generally There are numerous exceptions to this general secured by debt obligations which may include rule, including for liens securing purchase term loans and high yield bonds. These money debt and certain tax, ERISA and other vehicles have become major players in the statutory liens. In addition, with respect to secondary debt markets and have played an many types of collateral, certain methods of important role in developing a liquid secondary perfection, such as possession or control, may market for term loans and high yield bonds. be entitled to priority over an earlier security For tax reasons, these vehicles do not invest interest that is perfected solely by the filing of in the primary debt offering, but will often a financing statement. acquire debt securities in the secondary mar- 8 We are not aware of a general fiduciary duty ket within a few days after the initial offering. owed by a senior secured creditor to a junior Since 2003, CBOs, CDOs and CLOs have secured creditor simply by having a senior been incorporating second lien term loans lien on common collateral. and second lien bonds in their portfolios. As 9 The UCC covers most types of tangible and investors, rating agencies and other market intangible personal property. Some of the players have become more familiar with significant categories of property not covered second lien financings, their treatment in by the UCC include: CBOs, CDOs and CLOs has been evolving and continues to evolve. Nevertheless, second • real estate (other than fixtures), lien term loans and second lien bonds are and • some types of intellectual property and will continue to be a part of the portfolios of • in most states, insurance policies and any many CBOs, CDOs and CLOs. claims under those policies (other than as 3 Anti-layering covenants are more typically proceeds of other collateral). found in bond indentures than in bank loan 10 The first lien debt generally does not provide facilities. a reciprocal waiver of its right to challenge 4 The exact wording of each anti-layering the second liens. As a practical matter, first covenant must be examined carefully to lien lenders will often be reluctant to chal- determine whether second lien debt will be lenge the second liens out of concern that a permitted. challenge could boomerang back on them. 5 Under the bankruptcy code, all unsecured The first and second liens tend to be granted claims are not treated equally. Certain under the same set of security documents or unsecured claims, called priority unsecured under separate but substantively identical claims, have the right to be paid in full before security documents. If there is a flaw in the any of the residual unsecured claims, called security documents that impairs the second general unsecured claims, are paid. Priority liens, there is a good possibility it will also unsecured claims include: impair the first liens. 11 • post-petition administrative expenses needed In the early stages of a case a debtor may to operate the bankrupt company (such as have no source of liquidity for operations other employees’ wages and other ordinary than cash collateral. As a result, if the debtor course operating expenses) or to pay is denied the use of cash collateral it may be lawyers, accountants and other professionals required to cease operations and liquidate. hired by the bankrupt company or certain As a practical matter, if a bankruptcy court is types of creditors; faced with either permitting use of cash collateral over a secured creditor’s objection • in an involuntary bankruptcy, “gap” claims, or causing the debtor to liquidate, the bank- which are ordinary course unsecured claims ruptcy court will routinely permit use of cash incurred between the bankruptcy filing collateral. Thus, as discussed in the text date and the appointment of a trustee or accompanying this note, first lien lenders entry of an order for relief; tend to concentrate their efforts not on seek- • certain pre-petition employees’ wages; ing to prevent such use, but rather on requir- • certain contributions to employee benefit ing that such use be conditioned on the plans; and debtor’s adherence to a tight operating budget. 12 • certain types of tax claims. Unless the court orders otherwise, at the 6 Any three unsecured or undersecured creditors auction, the second lien creditors can “credit- can commence an involuntary bankruptcy bid” (i.e. reduce dollar for dollar the cash case against a company if the total value of price payable by the second lien creditors for the auctioned asset by an amount equal to)

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the value of their interest in the collateral in issuers with indentures containing this excess of the value of the first lien creditors' mechanism have faced extensive SEC interest in the collateral. For example, assume comments during the registration process. that the bankrupt company owes $50 to the 18 See the SEC’s order granting Allied Waste first lien creditors and $200 to the second lien North America, Inc.’s application for an creditors. Both the first and second lien debt exemption from TIA Section 314(d) dated is secured solely by liens on an asset worth August 8, 2001 (Trust Indenture Act of 1939 $150. If a third party makes a cash bid of Release No. 2392). There, the SEC staff $120 for one of the bankrupt company’s agreed that Allied Waste was under no crown jewels, and there are no other bidders, obligation to deliver certificates or opinions of the first lien creditors will likely favor the sale fair value upon any release of collateral from because they will get paid off in full. By credit- the lien since neither the indenture trustee bidding, the second lien creditors are only nor the holders of the indenture securities required to cash-bid $50 (the value of the first had any control over these decisions. All such lien creditors’ interest in the collateral) and decisions were controlled by the first lien can credit-bid up to the full amount of their creditors. $200 debt. Credit-bidding allows 19 The filing of a financing statement does not second lien creditors to lower the cash perfect a security interest in money, deposit component of their bid, which gives them a accounts letter of credit rights as original col- competitive advantage over other bidders lateral and, in most cases, motor vehicles without credit-bid rights. (except to the extent those assets are proceeds 13 In theory, the court could construct a plan of other collateral), real property (other than providing for first and second lien creditors to fixtures) or any personal property excluded share in a defined pool of value and leave from Article 9 of the UCC. them to sort out their intercreditor relationship 20 The case is called In re Ionosphere Clubs, Inc., after the plan is confirmed and consummated. 134 B.R. 528 (Banker, S.D. N.V. 1991). In that That is not a likely result in practice since it case, three series (series A, B and C) of creditors would be difficult to obtain the approval of had a security interest in the same assets of the the creditors affected by such a classification. bankrupt company. The security interest for 14 In reality, waiving the right to challenge the each of the series A, B and C creditors was first liens may not be as big of a concession as granted in the same security agreement. The it might appear at first blush. As discussed in security agreement contained a single “granti- note 10 above, the first and second liens are ng clause” that granted one security interest in often granted at the same time and under favor of the series A, B and C creditors. The either a single set of security documents or sep- issue at stake in the case was whether the series arate sets of near identical security documents. A, B and C creditors held three separate If the first liens can be successfully challenged, secured claims or were co-owners of a single there is a reasonable chance the same case can combined claim. The answer would determine be made against the second liens. whether the series A creditors were entitled to 15 Typically, the second lien documents will also post-petition interest. provide for the concurrent release of any In bankruptcy, only an oversecured creditor is subsidiary guarantee upon the sale of all of entitled to post-petition interest. A creditor is the stock of that subsidiary or the sale of all oversecured if the value of its interest in its or substantially all of the assets owned by collateral exceeds the amount of its claim. If that subsidiary. the series A, B and C creditors each held a 16 Other common exceptions to a “blanket lien” separate secured claim, the series A creditors include one-third of the stock of certain foreign would be oversecured and the series B and C subsidiaries, and certain licenses issued by creditors would be undersecured. However, if governmental authorities (such as liquor the series A, B and C creditors were co-own- licenses or FCC licenses). These and other ers of a single combined secured claim, the exceptions from the “blanket lien” are often entire class, including the class A creditors, heavily negotiated and vary from deal to deal. would be undersecured. 17 Some earlier deals tried to steer clear of the The bankruptcy court held that the series A, annual audit requirement by including a B and C creditors were co-owners of a single general statement that the second lien debt secured claim because the series A, B and C would not be secured by stock of subsidiaries creditors were secured by a single security or intercompany loans to the extent the interest. The court stated that, if the three pledge of those securities would trigger the series had been secured by three separate audit requirement. However, the SEC has not liens on the collateral, there would have been favored this fall-away mechanism and those three separate secured claims.

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A Snapshot of Market Conditions In the Second Lien Market (Spring 2004)

Provision/Issue Secured High Yield Secured Term Loan Unsecured High FAQ and Page Bond Market Market Yield Bond Market Reference

Waiver of right to Typically waived Often waived, but Not applicable, since What Secured Creditor exercise remedies until repayment in waiver generally concept applies only to Rights do the Second against collateral full of first lien debt. expires after 90 to 180 secured creditors. Lien Debt Holders Bondholders usually days. May be fiercely Typically Waive During have a “silent second” negotiated point. Term the Period Before a lien. loan lenders usually Bankruptcy Filing? have a “quiet second.” (page 8)

Waiver of right to Waiver commonly Waiver commonly Waiver rarely given What Secured Creditor challenge validity, given and remains in given and remains in (even in junior Rights do the Second enforceability or effect until repayment effect until repayment subordinated debt Lien Debt Holders priority of first liens in full of first lien debt. in full of first lien debt. deals). Unsecured Typically Waive creditors have a right During the Period to challenge first liens Before a Bankruptcy? (or any other liens). (page 8)

Waiver of right to seek Typically waived, until Often waived, but may Not applicable, since What Secured Creditor “adequate protection” repayment in full of first be a fiercely negotiated concept applies only to Rights do the Second for second lien debt lien debt. point. secured creditors. Lien Debt Holders Typically Waive in a Bankruptcy? (pages 8-11)

Waiver of right to Typically waived until Typically waived until Almost never waived What Secured Creditor oppose adequate repayment in full of repayment in full of (even in junior Rights do the Second protection for the first first lien debt. first lien debt. subordinated debt Lien Debt Holders lien creditors deals). Unsecured Typically Waive in a Significance of this Significance of this creditors have standing Bankruptcy? waiver to second lien waiver to second lien to object to adequate (pages 8-11) bondholders is greater lenders is greater if the protection for first lien if the company in company in bankruptcy creditors. However, bankruptcy has valuable has valuable unen- given their status as unencumbered assets. cumbered assets. unsecured creditors, their objections may be difficult to sustain.

Advance consent to Advance consent Advance consent Advance consent almost What Secured Creditor use of cash collateral usually given. Consent usually given. Consent never given (even in Rights do the Second supported by the first is typically effective is typically effective junior subordinated Lien Debt Holders lien creditors until repayment in full until repayment in full debt deals). Unsecured Typically Waive in a of first lien debt. of the first lien debt. creditors have standing Bankruptcy? to object to the use of (pages 8-11) cash collateral. However, given their status as unsecured creditors, their objections may be difficult to sustain.

19 Number 382 | April 15, 2004 Latham & Watkins | Client Alert

A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued)

Provision/Issue Secured High Yield Secured Term Loan Unsecured High FAQ and Page Bond Market Market Yield Bond Market Reference

Advance consent to Advance consent Advance consent Advance consent What Secured Creditor any sale of collateral usually given. Consent usually given, but may almost never given Rights do the Second supported by the first is typically effective require that proceeds (even in junior Lien Debt Holders lien creditors until repayment in full be applied to subordinated debt Typically Waive in a of first lien debt. permanently reduce deals). Unsecured Bankruptcy? first lien debt. Consent creditors have (pages 8-11) is typically effective standing to object to until repayment in full sale of any assets of first lien debt. (including collateral for second lien debt). However, given their status as unsecured creditors, their objections may be difficult to sustain.

Advance consent Advance consent Advance consent Advance consent What Secured Creditor to DIP financing commonly given (if first commonly given (if almost never given Rights do the Second supported by the lien creditors “share first lien creditors (even in junior Lien Debt Holders first lien creditors the pain”). Consent is “share the pain”). subordinated debt Typically Waive in a typically effective until Consent is typically deals). Unsecured Bankruptcy? repayment in full of effective until creditors have (pages 8-11) first lien debt. repayment in full of standing to object to first lien debt. the terms of any proposed DIP financing. However, given their status as unsecured creditors, their objections may be difficult to sustain.

Waiver of voting rights Often, not waived at Generally not waived– Waiver almost never Does a “Silent Second” on a plan of all. Any waiver will waiver typically very given (even in junior Lien Creditor Ever End reorganization typically be limited to strongly resisted by subordinated debt up Worse Off Than an waiver of right to: second lien lenders. If deals). Unsecured Unsecured Creditor? waived, waivers would creditors have a right (pages 11-12) (1) vote in favor of plan take the same form as to vote on a plan of unless it contains for second lien bonds. reorganization. specific provisions; or (2) oppose a plan supported by the first lien creditors. Any waiver will often be strongly resisted by the second lien bondholders.

20 Number 382 | April 15, 2004 Latham & Watkins | Client Alert

A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued)

Provision/Issue Secured High Yield Secured Term Loan Unsecured High FAQ and Page Bond Market Market Yield Bond Market Reference

Release of second liens Generally, automatic Generally, automatic Not applicable since Who Controls Releases outside of bankruptcy release of second liens release of second liens concept applies only of Collateral Outside of on any asset sold in on any asset sold in to secured creditors. Bankruptcy? accordance with the accordance with all (page 12) “asset sale” covenant. provisions of the second lien term loan Different deals vary on documents. release of second liens outside of sale context. Outside of asset sales, Favored approach generally, no collateral gives first lien creditors can be released unless the “on/off” switch for required term loan both first and second lenders agree. Term liens except where the loan agreement may release is of all or require supermajority substantially all of the and or unanimous collateral (in which approval. We have case second lien generally only seen bondholders must also automatic releases of agree to the release of second liens as a result the second liens). Note of a release of the first favorable TIA results liens if the second lien with this approach. term loans are pari passu with second lien bonds that have this provision and that are being sold concurrently.

Release of second Generally, second lien Generally, second lien Not applicable since Who Controls Releases liens during bondholders will not lenders will not object concept applies only to of Collateral During a bankruptcy object to court-ordered to court-ordered asset secured creditors. Bankruptcy? asset sales as long as sales as long as the (page 12) the second liens attach second liens attach to to the sale proceeds. the sale proceeds.

21 Number 382 | April 15, 2004 Latham & Watkins | Client Alert

A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued)

Provision/Issue Secured High Yield Secured Term Unsecured High FAQ and Page Bond Market Loan Market Yield Bond Market Reference

Scope of collateral Endless variations are Numerous variations None. Do Second Lien package possible – first and are possible, but Lenders Get the second lien debt may generally will have Same Collateral as have overlapping or the same collateral First Lien Holders? completely separate as the first lien pools of collateral. If creditors. What are the Legal there is significant Issues Limiting overlap in collateral, the Scope of the in a registered offering Collateral Package or a 144A offering in Second Lien with registration Bond Deals? rights, the second lien bondholders generally What are the Practical will have less collateral Considerations than the first lien Limiting the Scope creditors, due to of Second Lien difficulty in getting Note Collateral? pledges of stock and (pages 12-14) intercompany debt and inclusion in many bond deals of a more generous general “basket.”

22 Number 382 | April 15, 2004 Latham & Watkins | Client Alert

A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued)

Provision/Issue Secured High Yield Secured Term Loan Unsecured High FAQ and Page Bond Market Market Yield Bond Market Reference

Cap on the amount of Commonly will be Commonly will be Cap on first lien debt Are There Any Limits first lien debt capped at fixed dollar capped at fixed dollar not applicable to on the Amount of amount (which typically amount (which typically unsecured second lien Future First Lien Debt? includes a cushion to includes a cushion to bonds or term loans. (page 14) allow “protective allow “protective In a senior unsecured advances”) or by advances”) or by bond deal, often the reference to maximum reference to maxi- amount of secured debt leverage ratio or other mum leverage ratio is capped based on financial test. or other financial test. negotiated secured debt “baskets.” In subordinated unsecured bond deals, all new debt can be incurred and secured subject only to compliance with a minimum fixed charge coverage ratio (typically 2.00:1.00 or 2.25:1.00). (In unsecured term loan agreements, the amount of secured debt is typically capped at a fixed dollar amount, and the types of secured debt that can be incurred are generally also restricted. Some “term loan B” deals have covenants normally associated with high yield bond offerings.)

Cap on the amount of Commonly will be Commonly will be See discussion under Are There Any Limits second lien debt capped based on a capped based on a “Cap on the amount of on the Amount of maximum leverage ratio maximum leverage first lien debt” above. Future Second Lien or other financial test. ratio or other financial Debt? test. (page 14)

Option to buy out first Not common. Not common. Not applicable. Can the Second Lien lien debt at par Creditors Purchase the First Lien Obligations? (pages 14-15)

23 Number 382 | April 15, 2004 Latham & Watkins | Client Alert

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24 Number 382 | April 15, 2004