AMERICAN INSTITUTE JOURNAL Issues and Information for Today’s Busy Insolvency Professional Second-Lien Financings: Good, Bad and Ugly

Written by: About the Authors proceedings in the bankruptcy case may Mark Berman1 affect the ability of the parties to Nixon Peabody LLP; Boston Jo Ann Brighton is special counsel with enforce the provisions of the [email protected] Kennedy Covington Lobdell & Hickman intercreditor agreement at a later time in Contributing Editor: in Charlotte, N.C. She is on the Advisory the case. Jo Ann J. Brighton2 Board of the ABI Law Review and is Maxim Crane Works Kennedy Covington Lobdell and Hickman Board Certified in Business Bankruptcy When first reviewing the Maxim Charlotte, N.C. Law by the American Board of Crane case, the initial question that [email protected] Certification. Mark Berman is a partner comes to mind, and which has been at Nixon Peabody LLP in Boston. his is the fourth installment in a posed to these authors, is this: What did series of articles that focus on the the first-lien lenders do wrong in parties’ actual experiences in 11 reorganization plan, a continuing documenting the pre-petition credit T facility? After all, the result of the cases where second-lien financings business operation, and both first- and Maxim Crane have hit the bankruptcy courts.3 In the second-lien lenders participating in the chapter 11 case was that third installment printed in the May reorganized company. In contrast, the senior lenders gave up some of their issue of the Journal, we explored the American Remanufactures cratered at contractual rights to seniority under the Atkins Nutritionals, the very start—unable to resolve the intercreditor agreement and their right Inc., et al, chapter differences between first- and second- to insist upon application of the 11 cases.4 This lien lenders on the terms of the debtor- absolute priority rule and allowed value fourth installment in-possession (DIP) credit facility. The to flow downhill not only to second-lien explores the Maxim case was converted to a chapter 7 lenders (who, given the economics of Crane and New World Pasta chapter 11 cases.5 As a Feature reminder, these re- the case, would have otherwise received Jo Ann J. Brighton ports are purely liquidation and the assets sold by the anecdotal.6 In the chapter 7 trustee. In our view, nobody nothing), but also to unsecured prior installments, we explored how benefited by the battle over rights creditors. The answer surprises many Atkins resulted in a confirmed chapter between the first- and second-lien bankers and nontraditional lenders, but holders contained in the intercreditor should not surprise bankruptcy 1 Mark Berman’s practice concentrates on bankruptcy law, workouts and agreement. professionals who have experience with commercial law. He is an active member of the Boston Bar Association, the practical realities of the bankruptcy where he chaired its Bankruptcy Law Committee from 1990-92, served In this installment, as chair of its Business Law Section from 1995-97, and currently process. Very simply, the answer is serves as a member of its Bankruptcy Section’s Steering Committee. we will see first how Mr. Berman has taught courses in credit law and business law for the Maxim Crane high- “nothing.” There was nothing “wrong” New England Institute for Credit from 1989-2002 and is currently a with the intercreditor document—nor facilitator for those same courses taught online on behalf of the National lights the potential Association of Credit Management. He served as a member of the Client benefits of a nego- was there any legal weakness in the Security Board for the Commonwealth of Massachusetts from 1997 to position of the first-lien lenders. 2002 and is listed in Woodward and White’s “The Best Lawyers in tiated resolution via America” and in Chambers USA’s “America’s Leading Attorneys for Conversations with counsel involved in Business,” each for his expertise in bankruptcy law. the bankruptcy pro- 2 Jo Ann Brighton practices primarily in the area of bankruptcy, workouts cess in contrast to the case confirm that the agreement by and secured lending. She is a co-chair of ABI’s Business Reorganization the first-lien lenders to allow some Committee. the strict enforce- 3 For the prior installments of this series, see Berman, Mark, Brighton, Jo value to trickle down to the second-lien Ann J., “Second Lien Financing: More Questions than Answers,” ABI Mark N. Berman ment of the contrac- Journal, Vol. XXV, No. 2 (February 2006); Berman, Mark, Brighton, Jo Ann tual rights found in lenders and unsecured creditors was J., “Second Lien Financing Part II: Anecdotes: The Good, the Bad, and the instead driven by their desire to (1) see Very Ugly,” ABI Journal, Vol. XXV, No. 2 (March 2006); Berman, Mark, intercreditor agreements. Then we will Brighton, Jo Ann J., “Second Lien Financing Part III: Anecdotes: The Good, the case move along quickly, (2) the Bad, and the Very Ugly, ABI Journal, Vol. XXV, No. 4 (May 2006). turn our attention to New World Pasta, 4 (Delaware-Case No. 05-200022) (filed 11/7/05) (Judge Walsh). See, also, which illustrates how the crucial early participate in the DIP loan, (3) receive Berman, Mark, Brighton, Jo Ann J., “Second Lien Financing Anecdotes: payment more quickly (and with more The Good, the Bad, and the Very Ugly,” ABI Journal, Vol. XXV, No. 4 (May 2006). 6 The authors reviewed some, but not all, of the pleadings and spoke to certainty as to amount) and (4) 5 Parent case was ACR Management LLC et al., No. 04-27848 (W.D. Pa. some, but not all, of the parties involved in the case discussed in this filed June 14, 2004). In re New World Pasta, No. 04-02817 (M.D. Pa. article. Our sincere apologies if any information we report in this article eliminate risk. filed May 10, 2004). is incorrect or if the motivations we speculate about are inaccurate. 44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org To set the stage for this discussion: lenders and their position was slightly unsecured creditors could use the The debtors, headquartered in Pitts- underwater, and the intercreditor chapter 11 forum to argue about the burgh, constituted North America’s agreement was enforceable, why would validity, priority and amount of the first- largest crane-rental operation. They had the A lenders agree to any lien lenders’ secured claims, contest the an assumed of recovery at all for the junior lenders and terms of the DIP credit facility, contest approximately $475 million. Arrayed unsecured creditors? The answer lies in the of the reorganized debtors, against that value was that totaled the first-lien lenders’ recognition of and otherwise cause the chapter 11 case about $700 million. The debt was how the bankruptcy process works: to be expensive, time consuming and divided into four levels. The senior, or Time is short, resources are limited, bitter. After all, if the junior creditors Tranche A lenders, were secured by a assets are worth what they are worth, are not allowed to share in the recovery, first lien on all assets and were owed and, as the American Remanufactures there is little for them to lose and much approximately $473 million. Tranche B case demonstrates, sometimes it does to be gained if they are ultimately held a junior lien on all assets and was not make sense to stand on your rights successful (even marginally). Certainly, owed about $50 million. Tranche C, and fight for the sake of fighting. The the first-lien lenders might be able to also secured by a lien on assets, was disclosure statement reveals the first- fight back by trying to stand on their owed $9.1 million. A fourth level of lien lenders’ dilemma. While the rights to absolute priority and seek to secured notes was owed about $190 enterprise value of $475 million meant enforce the terms of the intercreditor million. Clearly, given the reality of the that the senior lenders were just a bit agreement. However, it is not clear that value of the debtor’s assets and the underwater, a chapter 7 liquidation was a bankruptcy court will take jurisdiction costs of the reorganization process, no projected to result in a substantial loss of disputes between secured creditors creditors besides those in Tranche A of value where the first-lien lenders over the enforceability of an “should” have received anything. would recover only 45 percent of what intercreditor agreement and that would A pre-negotiated plan had been they were owed. It was obvious that the leave the senior lenders with nothing agreed upon prior to the debtors’ first-lien lenders wanted—and more than a state court breach of bankruptcy filing. It provided that the needed—to find a way to realize a contract claim to pursue. Furthermore, first-lien lenders would receive a 90 going-concern value and avoid unsecured creditors are not party to the percent recovery with some of that liquidation. To accomplish this goal, the intercreditor agreement and are return represented by participation in a first-lien lenders made the decision to therefore free to raise any of these issues new secured credit facility and the distribute some of that enterprise value without fear of reprisal from the senior balance in most of the equity of the to other constituencies but secured to lenders. An enlightened first-lien lender reorganized debtor. The second-lien themselves a sure return of substantial will often be eager to limit the length of lenders would receive 9 percent of the proportion. This made the case a the chapter 11 proceeding, cut down on common of the reorganized relatively brief one, maintained the the resultant legal and other professional debtor plus warrants. Their recovery going-concern value of the business, fees associated with a long and was represented in the disclosure eliminated any risk that a greater value contentious chapter 11 case, and statement as worth 43 percent of what might have been found by the court in a produce a result that exceeds what they were owed. The third level of contested valuation dispute at would happen in a liquidation. The first- secured debt was to receive nothing, but confirmation, and left them in a lien lenders also might secure to that level was controlled by the first- position to enhance that recovery if the themselves the fees that flow from the lien lenders through an intercreditor reorganized debtors’ equity should DIP credit facility, avoid a costly agreement. The fourth level of secured increase in value. “[A]bsolute priority is valuation fight, obtain post-petition debt was to receive warrants. All of the often merely a theoretical starting point releases and secure to themselves the secured creditors were to receive from which the intercreditor vast majority of the upside represented releases. As the bankruptcy process negotiations depart.”7 More often than by control of the equity of the evolved, the first-lien lenders were able not, as the Atkins case highlights, reorganized business. to provide a DIP credit facility that parties fare much better when they New World Pasta, a.k.a. allowed them to earn additional fees work together with a recognition of a resulting in a greater than 90 percent common goal of maximizing recovery Ronzoni overall recovery for the first-lien as a whole. New World Pasta8 presents a lenders. A cash recovery and litigation There was simply no reason to different story. It’s another Penn- pool was structured for unsecured believe that the intercreditor agreement sylvania case begun about the same creditors that, depending on the in Maxim Crane was anything other time as Maxim Crane, but this one was litigation recoveries, would return than iron-clad and fully enforceable. in the Middle District of Pennsylvania. between 24 and 50 percent of what the However, the Maxim Crane first-lien No pre-negotiated plan was pursued. unsecured creditors were owed. The lenders were faced with the same Instead, the debtor came into the plan was confirmed six months after the quandary that most senior lenders face chapter 11 proceeding with a proposed chapter 11 filing, and the reorganized when they do not enjoy a recognized DIP credit facility to be provided by the debtor emerged from chapter 11 shortly and substantial equity cushion in first-lien lenders. However, the thereafter. collateral. Absent a negotiated proposed DIP order contained a clause Back to the initial question posed in agreement, junior secured and to which the second-lien lenders this discussion: If the Tranche A objected. It provided: 7 Kerr and Rovito, “Second-Lien Evolution Creates Higher Recovery lenders were truly senior to the other Prospects—At First Lien Lenders’ Expense,” Ratings Direct, Aug. 22, 2005. 8 In re New World Pasta, No. 04-02817 (M.D. Pa. filed May 10, 2004). 44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org The rights and remedies of the use of cash collateral and the adequate- Counsel involved in the dispute have pre-petition junior lenders, with protection finding (the “order”).13 It shared that the objections filed by the respect to the subordinate specifically approved the second-lien lenders were resolved obligations, if any, shall only be of payment of the junior creditors to the consensually. Specifically, the exercised in a manner consistent senior creditors.14 However, the final “offending language,” and any with and subject to the pre- order dropped the “offending language” appearance of approval of the petition credit agreement and and replaced it with: underlying waivers or injunctive or pre-petition participation agree- 38. Pre-petition Participation declaratory relief, was removed and ments. Agreement. Notwithstanding replaced with reservations of rights by Clearly, the first-lien lenders wanted anything in this order to the all. In other words, the fight was the bankruptcy court to order the contrary, the pre-petition parti- reserved for a later day. second-lien lenders to abide by the cipation agreements are in full While the New World Pasta case terms of the intercreditor agreements. force and effect, and nothing does not answer the question of the The second-lien lenders were astute, herein shall alter, modify, amend enforceability of the waivers and other picked up on the goals of the first-lien or effect the terms and concessions typically found in the lenders and sought to avoid that result. conditions of the pre-petition intercreditor agreements that ac- Objections were filed by the junior participation agreements, and company silent second liens, it is lienholders to the motions requesting nothing herein is or shall be instructive in many ways. First, the approval of the DIP financing, the use deemed a waiver of any rights or order confirms that there are no clear of cash collateral and the adequate remedies of the pre-petition answers to the question at hand. protection finding (the “Objections”). In agent or pre-petition senior Second, the objection filed by the the Objections, the junior lienholders lenders thereunder. Nothing in second-lien lenders suggests that acknowledged that the debtor needed this order shall be deemed to approval of DIP financing, cash the post-petition financing on a super- alter, amend, prejudice or waive collateral and adequate protection in priority basis, but requested that the the rights of the pre-petition bankruptcy cases involving pre-petition court strike certain provisions of the senior lenders or the pre-petition facilities with second liens may be DIP order as “offending language” junior lenders with respect to the construed as a blessing of the since, in the objecting creditors’ subordinate obligations under underlying loan documents and the opinion, that language “potentially the pre-petition credit agreement waivers they contain. The ultimate deprives the pre-petition junior lenders and the pre-petition participation change in the language seems to imply of fundamental bankruptcy rights and agreements, provided, however, that such a conclusion is possible and protections that cannot be traded away that in the event a court of may in fact act as an estoppel against in pre-petition agreements to the extent appropriate jurisdiction finds raising the issues later. that [such agreements] purport to do that the pre-petition junior Finally, New World Pasta reveals so.”9 The “offending language” had lenders’ and/or JLL’s agreements why the issue of the enforceability of been crafted by the first-lien lenders and and waivers contained in the various provisions in intercreditor placed into the DIP order in order to pre-petition credit agreement agreements of bankruptcy cases may enforce provisions of the inter-creditor and/or the pre-petition partici- never be resolved in a reported agreement—namely, a waiver from the pation agreements are enforce- decision. These issues are often pre-petition junior lenders of the rights able, the pre-petition agent consensually resolved in the early days to adequate protection and to vote on the preserves its rights to enforce of the case while the debtor hangs chapter 11 plan.10 The Objections such agreements and waivers precariously awaiting its DIP financing acknowledged the cases previously cited retroactively to the petition date, or resolved in the context of a larger by these authors concerning the including revoking any pro- settlement allocating value amongst the enforceability of certain provisions of tections previously granted to various levels of debt. As discussed the intercreditor agreement and argued the pre-petition junior lenders earlier, once a bankruptcy case is filed, that any order approving the DIP and/or JLL (including, without time is short: DIP financing and financing and authorizing cash collateral limitation, those protections con- permission to use cash collateral need should not be used to obtain declaratory tained in that certain stipulation to be in place essentially before the case or injunctive relief on these unsettled and Agreed Interim Order is filed. In a majority of cases, the issues of the enforceability of waiver entered by this court on May 10, borrower/debtor is so highly leveraged provisions by junior lienholders in 2004, and any final order entered that there is no ability to wage a bankruptcy cases.11 The Objections with respect thereto), which successful priming fight, and DIP credit further argued that the enforceability of protections upon such revocation facilities provided by the pre-petition the “offending language” can only be shall be deemed void ab initio senior lenders are the only real game in properly decided as part of an adversary and of no force and effect. town. Issues need to be resolved proceeding.12 There is no reported decision that quickly, and no one benefits, not the The New World court issued a final explains the basis for the court’s order. least of which the junior lenders, if order approving the DIP financing, the precious time is lost and the borrower’s 13 In re New World Pasta, No. 04-02817 (M.D. Pa. filed May 10, 2004) (issuing final order authorizing (a) secured post-petition financing on a money is spent on litigating valuation 9 See 2004 WL 1484987 at 2. super-priority basis pursuant to 11 U.S.C. §364, (b) use of cash or intercreditor issues. Settlement is 10 Id. at 3. collateral pursuant to 11 U.S.C. §363 and (c) grant of adequate 11 Id. protection pursuant to 11 U.S.C. §§363 and 364, entered July 9, 2004.). often in everyone’s best interest. It may 12 Id. 14 Id. at 9, 25-26. be worthwhile for junior lenders to involved second-lien financings and litigate waivers or assignments of their report to you on the resultant right to vote their claims at plan intercreditor issues. ■ confirmation time and to engage in a Reprinted with permission from the ABI valuation fight at that time, but in the Journal, Vol. XXV, No. 5, June 2006. meantime, all issues of the enforceability of intercreditor The American Bankruptcy Institute is a provisions concerning DIP financing, multi-disciplinary, nonpartisan orga- the use of cash collateral, the right to nization devoted to bankruptcy issues. ABI adequate protection, the release of liens has more than 11,500 members, on sales of collateral and the right to representing all facets of the insolvency seek relief from the automatic stay have field. For more information, visit ABI World faded into the past. In the meantime, at www.abiworld.org. waivers or assignments of the right to vote the claims of the second-lien lenders are becoming increasingly less common in intercreditor agreements used in second-lien financings. It is simply likely that by the time most plans are presented for confirmation, most of these issues will have also been resolved consensually by the parties. Conclusion In the end, Maxim Crane was a simple balance-sheet restructuring in which the parties, as in Atkins, agreed to work together. The Tranche A lenders’ recovery of more than 90 percent is not bad for any bankruptcy case and avoided the disaster of a liquidation. The second lienholders and unsecured creditors happily received a recovery they would not otherwise be entitled to based on the assumed enterprise value. Even more impressive, Maxim Crane was in and out of bankruptcy in approximately six months. New World Pasta also demonstrates the advantages of settlement. However, first-lien lenders would be wise to try to “shore up” their positions in DIP and cash collateral pleadings (although query whether such beneficial language would be enforceable if it is buried in the hundreds of pages of first-day pleadings and the bankruptcy judge has not been made aware of the implications of the specific language blessing the intercreditor agreement). Second lienholders should carefully review all DIP, cash collateral and adequate- protection motions made early in the case, as well as the proposed orders submitted by debtors and first-lien lenders acting in concert. At the very least, junior lienholders should file a limited objection reserving all rights to raise enforceability issues under the provisions of the intercreditor agreement. Stay tuned. We pledge to scour the horizon for other bankruptcy cases that