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Monday, october 15, 2007 When Second Lien Lenders Break Their ‘Silence’ All waivers in intercreditor agreements may not be enforceable.

By Jeffrey D. Saferstein In addition, many intercreditor agreements they could otherwise assert in a bankruptcy case. and Penny L. Dearborn often contain provisions that subordinate or However, these bankruptcy waivers can leave waive many of the second lien lenders’ rights, second lien lenders with fewer rights than general S THE NEXT WAVE of corporate as a secured creditor, to the senior lender if the unsecured creditors. Waivers can include the bankruptcies approaches, holders of borrower defaults or seeks bankruptcy protection; right to object to chapter 11 financing, assets A first lien debt that have negotiated such liens are generally referred to as “silent sales, motions by the senior lenders to lift the intercreditor agreements with second lien lenders second liens.” automatic stay to foreclose on collateral, and may be well served to dust off their transaction Although bankruptcy courts generally confirmation of any plan of reorganization. acknowledge and enforce provisions of The following are the most common waivers documents to see what rights they have against intercreditor agreements that subordinate a made by second lien lenders: second lien lenders in a Chapter 11 case of their second lien lender’s right to payments from • Automatic Stay. The Bankruptcy Code borrower. More importantly, the first lien lenders proceeds of shared collateral under §510(a) of the provides that the commencement of a bankruptcy may want to seek advice on whether those rights Bankruptcy Code, enforceability of intercreditor case under any chapter automatically enjoins, agreement provisions that go beyond mere without the need for a court order, all actions are enforceable. payment subordination is unclear. Specifically, (with certain exceptions) to pursue or collect on What Is a Second Lien Loan? there is uncertainty regarding whether and to pre-bankruptcy claims against the debtor, obtain what extent bankruptcy courts will enforce possession of property of the estate, or obtain a Second lien loans are loans that are secured provisions in intercreditor agreements lien on property of the estate. This injunction on a second-priority basis by all or part of the whereby second lien lenders have waived is known as the “automatic stay.” same collateral that secures the borrower’s senior their statutory rights and remedies under the The automatic stay benefits the debtor secured loan. Bankruptcy Code. by giving it relief from creditors’ collection In a second lien financing, the second lien efforts and benefits the debtor’s creditors by ranks junior to the first lien as a result of the The Rights Generally Waived (a) preserving the debtor’s going concern second lien lenders contractually agreeing, value and (b) maintaining the status quo, pursuant to an intercreditor agreement, to Due to the fact that transactions involving thereby preventing creditors from obtaining subordinate their rights and remedies with respect second liens are highly leveraged, a borrower in a disproportionate recoveries in comparison with to the shared collateral to the rights and remedies distressed situation might find that it is necessary similarly-situated creditors. of the first lien lenders until the debt secured by to seek bankruptcy protection. Accordingly, In certain circumstances, first lien lenders the first lien is paid in full. when negotiating the subordination terms may want to seek relief from the automatic in intercreditor agreements, first and second stay to foreclose on certain collateral. They Jeffrey D. Saferstein is a partner and lien lenders must anticipate the effect of a will typically want to be able to do this without Penny L. Dearborn is an associate in bankruptcy case. interference from second lien lenders who, the bankruptcy & corporate restructuring First lien lenders will often insist that second without an intercreditor agreement, will have department of Paul, Weiss, Rifkind, Wharton lien holders waive certain of their rights as rights with respect to the collateral. To prevent & Garrison LLP. secured creditors, including statutory rights that such interference, first lien lenders will negotiate New York Law Journal Monday, october 15, 2007

a provision in an intercreditor agreement that voting rights is rare as it can result in the second produced differing results. Accordingly, whether provides for the second lien lenders to waive in lien lender being worse off than if it were a bankruptcy courts will enforce provisions in advance their right to object to an attempt by the general unsecured creditor. Two compromises intercreditor agreements limiting the exercise of first lien lender to lift the automatic stay. that are often struck when negotiating this second lien lenders’ statutory rights and remedies • Post-Bankruptcy Financing. To operate in provision are: in bankruptcy is unclear. chapter 11, a debtor in possession often requires (i) that first lien lenders will require a covenant The following is a discussion of the notable post-petition financing (so-called “DIP Loans”). by the second lien lender to support any plan cases that address these issues: To encourage lenders to loan to debtors post- proposed by the first lien lender, and Relief From Automatic Stay Waivers/ petition, the Bankruptcy Code permits lenders (ii) if the proposed plan pays the first lien Adequate Protection Waivers. The bankruptcy providing such credit to: lenders in full, then the second lien lender court in the District of Minnesota, in the Hart (a) obtain collateral, can support any plan (or propose any plan) Ski Manufacturing Company 1 case, addressed the (b) obtain a “superpriority” claim ahead of all it wishes. situation in which the senior lender objected to other creditors, and • Asset Sales. First lien lenders will also the junior lender’s motion that sought adequate (c) prime existing security interests if the typically request that second lien lenders waive protection or the lifting of the automatic stay existing secured creditor’s interest in the collateral the right to oppose the sale of collateral in an based on language contained in the subordination is adequately protected. asset sale (pursuant to §363 of the Bankruptcy agreement between the parties. In addition to post-petition financing, in Code, which is a sale of assets in chapter 11 cases The senior lender objected on the grounds certain circumstances a debtor can use cash out of the ordinary course of business), which is that the junior lender had waived these rights in that is otherwise pledged as collateral to its proposed by the first lien lenders. the subordination agreement. The bankruptcy lender if certain requirements are met under the court declined to enforce the provisions at issue Bankruptcy Code. To obtain the DIP Loan or to xxxxxxxxxxxxxx and held that Congress never intended parties to use cash collateral, the debtor must show that Although outcomes in recent contractually alter the bankruptcy laws unrelated the secured lenders are “adequately protected,” cases vary widely, they illustrate to distribution. i.e., that such secured creditors will not suffer Specifically, the court noted that the diminution of the collateral value. that, when parties in a Bankruptcy Code guarantees each creditor’s To maintain their senior position and to bankruptcy case are faced with rights regardless of pre-bankruptcy waivers, control the process, first lien lenders will want the rapid diminution in value including the “right to assert and prove its claim, second lien lenders to waive their right to object the right to seek court-ordered protection for its to adequate protection arrangements. In such a of the estate’s assets, all parties security, the right to have the stay lifted under situation, second lien lenders would be unable (no matter how certain they proper circumstances, the right to participate in to oppose egregious terms for DIP financing or voting on any plan of reorganization, the right the use of cash collateral. are of their position) may be to object to confirmation and the right to file a Often, however, second lien lenders negotiate better served by expeditiously plan where applicable[.]”2 for the right to object on any basis that would negotiating a consensual DIP Loan Waivers. In New World Pasta,3 otherwise be available to general unsecured the bankruptcy court for the Middle District creditors, in exchange for waiving their right settlement rather than risking of Pennsylvania dealt with a dispute over the to object on the grounds that are based upon the lengthy, uncertain litigation enforceability of a waiver by the junior lenders second lien lenders’ collateral position. of the issues. to object to DIP financing. • Voting Restrictions. In order for a chapter xxxxxxxxxxxxxx There, objections were filed by second lien 11 plan of reorganization to be confirmed, the lenders to the motions requesting approval of a Bankruptcy Code provides that the plan must be DIP financing facility, use of cash collateral, and accepted by each class that is impaired, or it must adequate protection. The second lien lenders otherwise comply with the Bankruptcy Code. Second lien lenders will be opposed to acknowledged the necessity of the DIP financing, For a class to accept a chapter 11 plan, the accepting such a waiver, as it is far easier to sell but objected to including, in the order approving plan must be accepted by creditors that hold assets in bankruptcy without paying off all debts the financing, language that would bind the at least two-thirds in amount and more than and thus, such a waiver has the effect of taking second lien lenders to pre-bankruptcy waivers one-half in number of the allowed claims of away rights that a general unsecured creditor of their rights to adequate protection and to vote such class. To ensure that the first lien lenders would have. However, second lien lenders for or against any proposed chapter 11 plan. control the plan confirmation process and that often accept such a limitation in exchange for The second lien lenders also argued, relying on the second lien lenders do not try to hold up the the benefit of obtaining priority over unsecured such cases as Hart Ski, that such pre-bankruptcy process by voting against a plan that is favored creditors—their second lien on the assets. waivers were legally unenforceable. The New by the first lien lenders, first lien lenders typically World Pasta court issued a final order approving require second lien lenders to assign them the Enforceable in Bankruptcy? the DIP financing, the use of cash collateral, right to vote their claim. In this situation, the and adequate protection; however, the order did negotiated intercreditor agreement will include The prevalence of these waivers in second lien not contain the originally proposed language restrictions on the rights of the second lien lender financing make the enforcement by bankruptcy binding the second lien lenders to their pre- with respect to voting on a plan. courts a pivotal issue in bankruptcy cases. bankruptcy waivers, but was replaced with A full waiver of the second lien lender’s Currently, the few reported decisions have language reserving all parties’ rights in respect New York Law Journal Monday, october 15, 2007

of the waivers (in essence, the fight was reserved In the subsequent bankruptcy case, the first a legal determination by a bankruptcy court on for a later date). lien lender voted both its claim as well as that the issues of enforceability of certain waivers and Voting Waivers. In 203 North LaSalle Street of the second lien lender’s claim in favor of the have instead chosen to deal with the second Partnership,4 a senior lender brought an action reorganization plan. The second lien lender, lien loan structure and the second lien lender’s in bankruptcy court to enforce a provision in its however, declined to accept the plan, casting bankruptcy waivers through negotiations.5 intercreditor agreement that allowed the senior a “no” ballot on its behalf and filed a motion Although the outcomes in these cases varied lender to vote the claims of the junior lender in the bankruptcy court to determine who was widely, these examples aptly illustrate that, when on a chapter 11 plan. The court determined entitled to vote its claim. The second lien lender parties in a bankruptcy case are faced with the that subordination affects only the priority of argued that the right of the first lien lender, under rapid diminution in value of the estate’s assets, all payment and does not allow for a waiver of the terms of the subordination agreement, to parties (no matter how certain they are of their voting rights. vote on behalf of the second lien lender in the position) may be better served by expeditiously The bankruptcy court provided several reasons debtor’s bankruptcy case was unenforceable, negotiating a consensual settlement rather for its holding: relying primarily on the earlier decision in than risking a lengthy and uncertain litigation (i) private parties cannot contract away the North LaSalle. of the issues. policies of the Bankruptcy Code; Notwithstanding the North LaSalle decision, The limited caselaw that does exist offers (ii) the common meaning of “subordination” the bankruptcy court in Aerosol Packaging held conflicting opinions on the enforceability of relates to the ranking of claims, not the waiver that the subordination agreement at issue was the “silence” that second lien lenders agreed of rights; enforceable, finding that: to pursuant to intercreditor agreements. (iii) Bankruptcy Rule 3018(c) does not allow (i) although §1126 (a) of the Bankruptcy Accordingly, there is little definitive guidance. for the voting of subordinated creditor’s claims Code grants the holder of a claim a right to vote, The one certainty, however, is that the by the senior creditor; and it is silent as to the holder’s ability to delegate or increasing prevalence of second lien financings (iv) as the subordinated creditor may still bargain away such voting rights; and the concomitant bankruptcy filings assures receive payments in bankruptcy proceedings, (ii) §510 (a) of the Bankruptcy Code permits that first lien and second lien lenders will face general bankruptcy policy dictates that they the enforcement of subordination agreements in these issues and the attendant uncertainty early should play a role in plan negotiation. bankruptcy to the extent they are enforceable in Chapter 11 cases. Accordingly, the court invalidated the under applicable non-bankruptcy law, and the intercreditor agreement. pertinent state law does not prevent enforcement ••••••••••••••••••••••••••••• We note that there are other cases, however, of voting rights in the instant case; and 1. Beatrice Foods Co. v. Hart Ski Mfg. Co., Inc. (In that have held that plan-voting restrictions in (iii) Federal Rules of Bankruptcy Procedure re Hart Ski Mfg. Co.), 5 B.R. 734 (Bankr. D. Minn. 1980). intercreditor agreements are enforceable. See In 9010(c) and 3018(c) both expressly permit 2. Id. at 736. re Curtis Center Ltd. P’ship, 192 B.R. 648, 660 agents and other representatives to take actions, 3. In re New World Pasta Co., Case No. 04-02817 (Bankr. E.D. Pa. 1996) (enforcing subordination including voting, and such actions need not (Bankr. M.D. Pa. 2004). agreement provision assigning junior creditor’s comply with the direction of the principal. 4. Bank of America v. North LaSalle Street Ltd. P’ship (In re 203 North LaSalle Street Ltd. P’ship), 246 B.R. 325 bankruptcy voting rights to senior creditor); In As a result of the ruling, the Aerosol Packaging (Bankr. N.D. Ill. 2000). re Inter Urban Broad. of Cincinnati, Inc.,1994 court declined to recognize the ballot filed by 5. For a discussion of these cases, see Berman, Mark, WL 646176 (E.D. La. 1994) (same). the second lien lender. The court concluded its Brighton, Jo Ann J., “Second-Lien Financings Part II: In addition, the bankruptcy court for the decision by noting that the second lien lender Anecdotes and Speculation—the Good, Bad and Ugly,” American Bankruptcy Institute Journal, Vol. XXV, No. 2 Northern District of Georgia recently joined was not without a remedy, as it always has the (March 2006) (discussing the negotiations between the this line of cases by enforcing a provision in option to reclaim its voting rights by making a first lien lender and second lien lender in the American the intercreditor agreement that gave the senior full cash payment to the first lien lender. Remanufacturers case); Berman, Mark, Brighton, Jo Ann J., “Second-Lien Financings Part III: Anecdotes and creditor the right to vote a junior creditor’s claim. Speculation—the Good, Bad and Ugly, Atkins—the Blue Ridge Investors, II, LP v. Wachovia Bank, Conclusion Good,” American Bankruptcy Institute Journal, Vol. N.A. (In re Aerosol Packaging, LLC), 362 B.R. XXV, No. 4 (May 2006) (discussing the negotiations 43 (Bankr. N.D. Ga. 2006). Few courts have addressed the issue of between the first lien lender and the second lien lender in the Atkins Nutritional case). In Aerosol Packaging, the parties negotiated enforceability of the provisions contained in a subordination agreement pursuant to which, intercreditor agreements pursuant to which among other things, the second lien lender’s second lien lenders agree to remain “silent” in claims and liens were subordinated in all respects bankruptcy cases. to the claims and liens of the first lien lender. The This dearth of caselaw is due, in part, to subordination agreement also provided that the the fact that the use of second lien financing first lien lender was entitled to (i) vote the claims is a relatively recent trend (and the inevitable of the second lien lender in any bankruptcy case defaults have yet to occur), as well as to the of the debtor; (ii) demand, sue, collect or receive fact that the nature of the bankruptcy process any distribution of any assets of the debtor to dictates that many of these intercreditor disputes the second lien lenders; and (iii) recover any get resolved before the issues get presented to a Reprinted with permission from the October 15, 2007 edition amounts due on the second lien lender’s claims bankruptcy judge. of the New York Law Journal. © 2007 ALM Properties, Inc. All rights reserved. Further duplication without permission until such time as the first lien lender’s claim There have been a few recent bankruptcy is prohibited. For information, contact 212-545-6111 or visit were paid in full in cash. cases in which the parties have agreed to forego www.almreprints.com. #070-10-07-0031