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Hands Off My Collateral: the Impact of Bankruptcy on a Wide Variety of Financing Structures

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Hands Off My Collateral: the Impact of Bankruptcy on a Wide Variety of Financing Structures Hands Off My Collateral: The Impact of Bankruptcy on a Wide Variety of Financing Structures Presented at the 44th Annual Seminar on Bankruptcy Law and Rules, Atlanta, Georgia March 22 –24, 2018 Manuscript: Alan W. Pope Moore & Van Allen PLLC Discussion Panel: The Honorable Paul Baisier Judge, United States Bankruptcy Court Northern District of Georgia Reginald Dawson Wells Fargo Bank, N.A. David L. Eades Moore & Van Allen PLLC Alan W. Pope Moore & Van Allen PLLC Introduction In preparing this manuscript, I sought to strike a balance between the legal and the practical. What on earth do I mean by that? Any presentation that in its title refers to a “Wide Range of Financing Structures” risks biting off more than it can chew. Financing structures are influenced not only by the underlying product being offered but by the market in which the financing is offered. For example, traditional leveraged finance products being offered to large companies at the behest of private equity firms enjoy the benefits of trade groups such as the LSTA,1 which recites as one of its core functions the standardization of legal documentation. Add the increasing use of “precedent” documents that are used to establish “Documentation Principles”2 at the term sheet stage, and you can easily make the case that the larger the deal, the easier the negotiation and documentation.3 Move down market, and the negotiation and documentation of any financing structure begins to look more like the Wild West. Lenders have greater leverage in the negotiations with smaller borrowers, and savvy junior capital providers are more willing to heavily negotiate intercreditor terms. As a practitioner who bores easily, I find this “middle market” to offer more fodder for discussion, particularly with respect to rights in collateral. 1 The Loan Syndications and Trading Association. Definitely visit www.lsta.org. 2 For those unfamiliar with the concept, many private equity funds prepare the initial drafts of their financing terms sheets and incorporate “Documentation Principles” which in effect, reference another credit facility and require that the contemplated new credit facility track the various covenants, definitions and related terms. 3 Given that many of these larger financings are broadly syndicated, participant lenders generally defer to the arrangers on terms, particularly where the financing is oversubscribed. In turn, many participants engage in only limited review of the loan documentation, perhaps under the arguable assumption that a secondary trading market will exist and allow for an exit, if the credit becomes distressed. 2 So for those practical reasons, I have focused this discussion on middle market intercreditor agreement negotiations that arise from different financing structures. Bankruptcy is the ever-present legal backdrop to those negotiations in terms of (i) the default rights of the parties in and to collateral and (ii) the enforcement of the resulting intercreditor agreement. Financing - what kind of financing? Loans, hedges, treasury management products, capital leases, aircraft leases, letters of credit, note issuances, securitizations, factoring: the number and types of financial products being offered in the marketplace constantly increases, evolves and grows. A hornbook4 could not cover this topic with respect to all of these products, so this manuscript will limit itself to traditional debt finance. Depending on the financing provider, debt finance often incorporates other products (e.g., letters of credit, hedging, treasury management) into the obligations established by the underlying credit facility, and their inclusion, with limited exceptions, does not alter the basic principles discussed herein. Debt finance does, however, offer a number of intercreditor structures to explore. Second Lien Transactions A good starting point is the first lien/second lien financing structure, where the name says it all. This structure involves a “first lien” loan secured by a senior priority lien in substantially all of the assets of a borrower, and a “second lien” loan, established under a separate credit facility and secured by a junior priority lien in the same collateral. The second lien facility is not subject to debt subordination, and, as such, shares pari passu in any unencumbered assets. The competing interests in the collateral require a separate intercreditor agreement to establish the subordination of the junior liens. Of 4 Are these still around? 3 course, traditional lien subordination language takes up about 2 pages of an otherwise 50 plus page document. Why? Because, to steal from the title of this manuscript, the first lien lender also wants the second lien lender to keep its “Hands Off My Collateral”. In other words, the intercreditor agreement is more about controlling the conduct of the competing lienholder. Why does this conduct matter? Financial distress at a borrower may result in the first lien lender and the second lien lender having very differing views as to the best workout strategy for the borrower. Given its senior interest in the collateral, the first lien may see asset sales or liquidation as a viable exit strategy, while the second lien lender, who often is relying on “enterprise” value rather than hard asset value, may want to preserve the business intact for a non-distressed sale or debt-for-equity reorganization. To that end, the first lien lender seeks to control pre-bankruptcy conduct in certain areas by obtaining agreements that: • the second lien lender will not act against the collateral if the second lien facility is in default (i.e., a remedy standstill) for a period of time, typically 120-180 days after notice of such default and/or acceleration; • the second lien lender will not interfere with an exercise of remedies by the first lien lender; • waive the second lien lender’s rights arising out of the second lien lender’s status as a secured creditor (e.g., appraisal, marshalling); 4 • allow for the first lien lender to work with the borrower to conduct a consensual post-default sale of assets for which the second lien lender must release its liens and, often, any related subsidiary guarantees; 5 and • restrict the amendment of the second lien facility. Please note that my focus here is on those agreements related to the collateral; there are numerous other waivers and restrictions in an intercreditor agreement dealing with more administrative matters (i.e., insurance, caps on debt amounts, assignment of the first lien or second lien obligations) that exceed the scope of this discussion. That being said, the primary principle at play is that a first lien creditor wants unfettered discretion in the administration and sale of its collateral so as to approximate treating the second lien lender as if it were an unsecured creditor.6 In the middle market, intercreditor negotiations increasingly focus on the sale and release of collateral outside of bankruptcy in acknowledgement of the (i) often prohibitively high administrative costs of bankruptcy and (ii) the possible diminution in the value of the enterprise simply as a result of being in bankruptcy. Sometimes, a bankruptcy is inevitable whether because of the degree of the distress, the nature of a proposed asset sale or the inability to obtain consent from a necessary stakeholder. The desire of a first lien creditor to retain unfettered control over the collateral now has a different legal framework, with the second lien lender picking up additional rights as a secured creditor under the Bankruptcy Code. The same types of 5 Practice point: we usually see language regarding the release of claims by a credit party in connection with the sale of stock of any such party; a junior creditor must be very careful to exclude its borrower from any such release, or it may result in a non-consensual forgiveness of the borrower’s debt. 6 The absence of an effective waiver of the rights of the second lien lender may lead to a “little something for the effort” moment and the resulting payment of a consent premium to the subordinated party. 5 agreements obtained for the out-of-court situation now have their bankruptcy corollaries. At a basic level, a first lien creditor seeks agreements that: • allow the first lien lender to consent to cash collateral use under §363 and priming DIP financings under §364 and waive the rights of the second lien lender to object to such actions on the basis of a lack of adequate protection; • allow the first lien lender to consent to carve-outs for professional and US Trustee fees; • allow the first lien lender to consent to sales and dispositions of collateral under the §363 and related provisions (and require the second lien lender to consent to such dispositions); • limit the ability of the second lien lender to seek cash adequate protection payments; • control the distribution of collateral proceeds; • limit the ability of the second lien lender to seek relief from the automatic stay; • establish that the claims of the first lien lender and the second lien lender must be separately classified under any plan or reorganization, and, if not, that any distribution is treated as if the claims had been separately classified; and 6 • prohibit challenges by the first lien lender and the second lien lender to the other lender’s liens. Recognizing that a regurgitation of every waiver in a second lien intercreditor does not serve this discussion, I would say that if a drafting attorney had addressed each of the above topics in an intercreditor, the document would be 80% of the way there. Why only 80%; isn’t that a C+ in school? The answer lies in the constant evolution of intercreditor agreements, and the lessons learned during the financial crisis when many of these agreements were tested in bankruptcy. Also, bankruptcy practice itself has created additional waivers on a “lessons learned” basis after first lien lenders were forced to pay a consent premium.
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