Bankruptcy Considerations for Second Lien Loans

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Bankruptcy considerations for second lien loans

Jeffrey N. Rich is partner and Elizabeth H. Singer is of counsel in the Bankruptcy, Insolvency, Business Reorganisation & Restructuring practice group at Kirkpatrick & Lockhart Nicholson Graham’s New York office. They can be reached at +1 (212) 536 3900 or BY JEFFREY N. RICH AND ELIZABETH H. SINGER via email at [email protected] and [email protected]

s reported in the January issue of Finan- also authorise the senior lender to act on its lien lenders. When reading the following, it cier Worldwide, second lien fi nancing is behalf. Indeed, intercreditor agreements often is important to consider the implications of theA fastest growing sector of debt structure empower a senior lender to vote a junior lend- these provisions in the context of a typical within the United States. Yet because this erʼs claim in connection with a Chapter 11 plan intercreditor agreement that precludes a junior boom is so recent, second lienholder markets or the appointment of a trustee. Some clauses lender from participating in the bankruptcy have yet to confront how their second liens even go so far as to pre-authorise the senior process. will be affected in a bankruptcy of the bor- lender to enter into a post-petition fi nancing rower. In determining the ultimate treatment agreement that is secured by liens with prior- Valuation issues of second liens in bankruptcy, several factors ity over those of the junior lender. Valuation of collateral is necessary in connec- are determinative. The fi rst and most signifi - By obtaining control of the bankruptcy tion with a number of critical issues in bank- cant is the terms of any prepetition intercredi- process through an intercreditor agreement, ruptcy. These include: tor agreement between the fi rst and second a senior lender can effectively “sell out” the lienholder. Other important factors are the junior lender for its own benefi t. This can be • requests for relief from automatic stay, value of the jointly held collateral, the debtorʼs accomplished through the negotiation of a • adequate protection issues, ability to effectuate a cram down in a Chap- Chapter 11 plan that is favourable to the senior • Chapter 11 cram downs; and ter 11 proceeding, and the debtorʼs ability to lender (which, for example, fi xes a benefi cial • whether a secured creditor is entitled to “strip away” the fi rst and/or second lien. Un- collateral value or payment stream) or through post-petition interest and charges. derstanding the nuanced interaction between a debtor-in-possession fi nancing facility that these various factors is critical to a complete grants superior lien interests to the senior lend- Understanding the purposes for, and methods evaluation of a junior lenderʼs portfolio. ers (effectively wiping out any equity in the of, valuation in the bankruptcy context is nec- junior lenderʼs collateral). essary for all secured creditors, and particular- Intercreditor agreements The interests of senior and junior lienholders ly holders of second liens, to understand their Intercreditor subordination agreements are en- usually confl ict on two principle issues: the potential exposure. forceable in bankruptcy and thus, directly af- valuation of collateral and the right to negoti- Under the Bankruptcy Code, a claim is a fect a junior lienholderʼs rights in a bankruptcy ate Chapter 11 plan provisions. However, there secured claim only to the extent of the “value” of the borrower. Typically, senior lenders de- are instances where the interests of the senior of the collateral and is an unsecured claim for mand as much control as possible and seek and junior lienholders are harmonious and, in the remainder. As a result, a junior lenderʼs to limit a junior lenderʼs rights, remedies and those instances, the junior lienholder should be secured claim will be reduced or eliminated by freedom of action upon default, especially in a entitled to act. the establishment of a collateral value that is bankruptcy context. Senior lenders will often The following is a summary of some key less than the aggregate of all senior and junior demand that a junior lender not only waive its bankruptcy concepts and rules that govern debt. right to participate in a bankruptcy proceeding the rights of secured creditors generally, and Since the Bankruptcy Code does not dictate (except for the fi ling of a proof of claim), but which have important implications for second the precise valuation method to be utilised by 8

This article fi rst appeared in Financier Worldwide’s June Issue 2005. © 2005 Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher. For further information on Financier Worldwide and its publications, please contact James Lowe on +44 (0)845 345 0456 or by email: james.lowe@fi nancierworldwide.com www.financierworldwide.com | June 2005 FW | REPRINT the courts, several different valuation methods those of the senior lenders. high value should be harmonious, except that have been adopted. These include: (i) replace- the junior lienholder has more reason to fi ght ment value; (ii) liquidation value; (iii) going Adequate protection and cash collateral for a higher value. concern value; or (iv) some other value (e.g., issues an intermediate value, book value, or depre- The Bankruptcy Code provides that a secured Section 1111(b) election ciation value). Going concern and replace- creditor is entitled to adequate protection Section 1111(b) of the Bankruptcy Code pro- ment values are often used in reorganisation against any diminution in value of its collateral vides secured creditors with special rights re- cases while liquidation value is often used in that is being used, sold or leased by the debtor. garding the treatment of their claims. Unless the bankruptcy liquidations. While valuation for Under the Code, an oversecured creditor is collateral is sold in the bankruptcy or pursuant to one purpose does not preclude a creditor from entitled to a claim for post-petition interest as a Chapter 11 plan, a secured creditor is entitled arguing a different value for another purpose, well as reasonable fees, costs and charges as to an unsecured defi ciency claim regardless of judges may resist changing their initial valua- provided for under the loan agreement. Un- whether the creditor had recourse on its claim. tions. Thus, the inability of a second lienholder less there is suffi cient value in the collateral to Section 1111(b)(2) provides special rights to to participate at the inception of valuation pay both senior and junior liens, any interest undersecured creditors and is thus signifi cant proceedings can have a dramatic effect on its paid on the senior lenderʼs debt will directly to junior lenders who are more likely to be position for the remainder of the case. decrease the junior lenderʼs equity. undersecured. Under this section, if a credi- It is in the junior lienholderʼs best interest to tor is undersecured, then it may elect to have Relief from the automatic stay establish as large an equity cushion or collat- its claim treated as an allowed secured claim Immediately upon the fi ling of a bankruptcy eral value as possible to preserve its position. to the full extent of the claim if the secured petition, a creditor is prohibited from tak- This is an example of the type of situation creditor can comply with the other terms of ing any action to collect a debt or recover that is often not adverse to a senior lender and this section. property of the debtor. The scope of the stay under which a junior lender might be able to Typically, an undersecured creditor would is broad and includes most collection activi- negotiate participation rights in the borrowerʼs want to make a section 1111(b)(2) election if ties. A secured creditor may seek relief from bankruptcy. it is unhappy with the treatment being offered the automatic stay if, among other things, the to unsecured creditors, or if it believes that the debtor lacks equity in the collateral. The se- Cramdown in Chapter 11 collateral is undervalued or likely to be sold at cured creditor, as the party seeking relief, has Section 1129(b) of the Bankruptcy Code, often a later date. On the other hand, if an underse- the burden of proving that the debtor lacks referred to as “cram down,” provides a means cured creditor believes that its unsecured defi - equity in the property at issue. In determining by which a debtor can seek confi rmation of a ciency claim will govern the vote of the class valuation for purposes of stay relief, no one plan over the objection of a secured creditor. of unsecured creditors and it wishes to defeat particular valuation method is used. Rather, Under section 1129(b)(2)(A)(i), the debtor the debtorʼs plan, then it should not make the courts will consider the specifi c facts and cir- must fi rst establish a lien value for the col- section 1111(b)(2) election. cumstances of the case, such as the nature of lateral. The US Supreme Court has held that the debtorʼs business, market conditions, the replacement cost to the debtor is the proper Conclusion debtorʼs prospects for rehabilitation, and the valuation method under this section of the The fees and interest rate charged by a sec- type of collateral. Bankruptcy Code. The Court gave the bank- ond lienholder must take into account the For purposes of determining whether a debtor ruptcy court, as the trier of fact, discretion to risk of bankruptcy of the borrower, and the lacks equity in collateral, the vast majority of determine the best way to ascertain replace- voluntary surrender of valuable participation courts will consider the difference between ment value. rights to a senior lender under an intercredi- the current value of the collateral and the total In that regard, the debtor may seek to estab- tor agreement. Moreover, since the interests of all liens on the collateral, including senior lish a low collateral value that wipes out the ju- of the senior and junior lender are not al- and junior liens. However, a small minority of nior lienholderʼs security interest and relegates ways adverse, it may be possible for a ju- bankruptcy courts have excluded junior lien- its claim to unsecured status. This is another nior lender to negotiate participation rights holdersʼ claims from the equity calculation if example of a situation where the interests of in bankruptcy where such interests are not the interests of junior lienholders differ from the senior and junior lienholders to establish a adverse.