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Home , Restructuring, Second lien loan, Senior debt, Subordinated debt, Subordination (finance)

VEDDERPRICE ® and Transactions Group

Winter 2008–2009 Special Report

“SECOND ”

Executive Summary. During the past few years, the financial markets have enabled borrowers to issue multiple layers of in sophisticated fi nancings, particularly in the case of highly leveraged companies. Thus, second lien fi nancing has not only become a recognized part of the of such fi nancings, but has experienced impressive expansion. The “market” terms that govern the second lien layer of debt evolved in light of increased involvement of nonbank investors (i.e., sponsors, hedge funds, distressed debt funds, etc.). As the continued level of involvement of these nonbank investors remains uncertain and the credit markets tighten, the relationships between senior and junior secured lenders will change and certain provisions not typically found in recent intercreditor agreements may once again surface. This article discusses in detail the recent progression of second lien fi nancing structures and certain relevant intercreditor provisions (including payment , enforcement actions, amendment rights and rights in ) that may face increased scrutiny by fi rst lien and second lien lenders alike. WWW.VEDDERPRICE.COM VEDDERPRICE

RECENT TRENDS IN SECOND LIEN LOANS

Over the past several years, lenders have offered quarterly reviews, between 2003 and 2005, borrowers many alternative fi nancing vehicles as second lien volume spiked from $3.1 billion to options for fi nancing their acquisitions, corporate $16.3 billion. By 2006, LCD that reported the or operations. The creative and volume increased to $28.3 billion; in 2007, the complex fi nancing structures that resulted gave volume grew to nearly $30 billion, with more than rise to many different classes and types of lien 90% of the loans funded during the fi rst three priorities. As became more affordable quarters of the year. Notwithstanding the rapid due to a prolonged period of low rates and growth over a relatively short period of time, this as traditional and other nontraditional loan product continued to evolve and its interplay investors, such as private equity sponsors, hedge within more traditional capital structures remained funds, distressed debt funds, competed to provide unclear. As a result, the terms of the intercreditor these various layers of structured fi nancing, the agreement—a critical document from the result was a marked increase in junior debt perspectives of both the First Lien Lender and the secured by a second lien. Second Lien Lender—varied, sometimes Financing involving a offers signifi cantly, among transactions. advantages for borrowers and lenders alike. During this period, documentation for very large, Second lien loans provide borrowers with an widely syndicated second lien loans remained additional source of capital and access to interest relatively uniform among transactions. Most other rates that are typically lower than those found in second lien loans (particularly middle-market “club” more traditional subordinated or mezzanine debt. deals) were characterized by a lack of uniformity. For the lenders, the fi rst lien lender (“First Lien Particularly during 2006 and the early part of 2007, Lender”) reduces its own credit exposure with Second Lien Lenders began to participate in respect to the borrower while enhancing the transactions that were less clearly borrower’s overall capital structure. The second overcollateralized. Further, the relatively few lien lender (“Second Lien Lender”) gains critical borrower defaults and provided fewer secured rights that are unavailable to opportunities for testing the terms of intercreditor unsecured (especially in the event of any agreements. The result was a decline in or bankruptcy proceeding involving the confi dence that loans made by Second Lien borrower), most prominently a position ahead of Lenders were relatively low-risk but would provide general trade creditors. high returns. The Second Lien Lenders began to Early-stage second lien loans were designed to demand additional rights and a greater provide temporary incremental liquidity for a level of involvement in enforcement actions. At specifi c purpose. They were funded by a small the same time, because the Second Lien Lender group of institutional investors focused on making often was providing a layer of capital that was loans to underperforming companies with unavailable elsewhere, the First Lien Lender at suffi cient collateral to cover both the fi rst lien times experienced signifi cant pressure from its obligations and the second lien obligations. As a own borrower to accommodate the requests of the result, these early investors were comfortable Second Lien Lender wherever possible. It was not making the investments with an understanding unusual to see the basic terms of the intercreditor that they would have few, if any, rights with respect agreement outlined in the fi rst lien fi nancing term to the collateral securing their loans (i.e., their sheet or commitment letter. The fully deferential would be “silent” liens). second lien structure that was the norm in early- Beginning in 2003, the rate of growth within the stage second lien loans began to change and the second lien loan market increased signifi cantly liens that were held by Second Lien Lenders could and rapidly. According to Standard & Poor’s be characterized more accurately as “muffl ed” Leveraged Commentary and Data (“LCD”) rather than “silent.”

2 Special Report Q Winter 2008–2009

The second lien loan market experienced a because the equity sponsor is acting as a lender of signifi cant drop in late 2007 and much of 2008 due last resort. No matter what the role of the Second to a variety of factors, most notably capital issues Lien Lender in the borrower’s capital structure, a affecting the largest participants in the second lien First Lien Lender must recognize and evaluate the debt market—hedge funds. When the second lien potential risks of delay or interference with its and markets again picked up in ability to exercise rights and remedies with respect 2009, recent transactions involving second lien to the borrower and the collateral that may result debt suggest that where second liens are from accommodating a Second Lien Lender’s permitted, they are allowed based on an requests for rights beyond merely having a second understanding that the Second Lien Lender should lien position. expect to enter into an intercreditor agreement on terms more akin to mezzanine terms and the PAYMENT SUBORDINATION earlier transactions than those that closed as As recently as the third quarter of 2007, it was recently as 2007 (or, at the very least, a hybrid of widely accepted that Second Lien Lenders should the two generations of documents) as highlighted not be expected to agree to payment subordination in this article. (also referred to as debt subordination) as a THE INTERCREDITOR AGREEMENT condition to receiving liens. A Second Lien Lender typically did not have to make the argument that it When a borrower’s debt structure includes a should not be required to subordinate its right to second lien loan, the intercreditor agreement that payment to the prior payment right of the First Lien will be entered into between the First Lien Lender Lender. A similar position championed by Second and the Second Lien Lender should take center Lien Lenders was that they should be permitted to stage and be the focus of early-stage negotiations. receive regularly scheduled payments on their debt The intercreditor agreement must act as a shield irrespective of whether a payment existed for the First Lien Lender against the actions of a under the fi rst lien loan documents, and initial Second Lien Lender when a borrower’s fi nancial drafts of intercreditor agreements were prepared situation or condition deteriorates by limiting the without including payment subordination or rights of the Second Lien Lender in a variety of payment blockage concepts. However, more subsequent actions or bankruptcy proceedings. recently, payment subordination and, particularly, Initially, it is important to focus on why the payment blockages are reappearing in second lien fi nancing structure includes a second lien loan, as intercreditor agreements. Even when a Second opposed to unsecured mezzanine loans. Lien Lender generally agrees that its payments will Developing this strategy early with respect to the be subordinated and blocked, considerable time is role a Second Lien Lender will play in the capital spent negotiating “when” these blocks will occur structure and the impact of that role on various and for “how long” they will last. A First Lien provisions of the intercreditor agreement is critical, Lender will want to consider blocking scheduled as many of the key provisions of an intercreditor payments in the event of any default under the fi rst agreement can be drafted in signifi cantly different lien loan documents. A Second Lien Lender ways depending on the relative strength of the (particularly one with signifi cant leverage) will Second Lien Lender’s bargaining power. For argue for no payment block or, at least, to limit any example, a Second Lien Lender that is providing payment blockage to certain material defaults capital that the First Lien Lender is unwilling—or under the fi rst lien documents (“Material Defaults”), unable—to provide may have more negotiating such as the following: (1) the existence of any power. Conversely, a Second Lien Lender that payment default; and (2) the existence of any also is the borrower’s equity sponsor has a weaker fi nancial covenant default. A First Lien Lender basis on which to demand more rights, often should evaluate a request to limit the scope of

3 VEDDERPRICE

Material Defaults very carefully to ensure that the In the event that payments are blocked, the First Lien Lender retains the right to block Second Lien Lender will seek to accrue and later payments in all circumstances where leakage to recapture any missed payments in the event that the Second Lien Lender may be detrimental to the such default is cured or waived. So long as the First Lien Lender. For example, if a borrower is payment is not otherwise blocked under the delinquent in meeting its fi nancial reporting intercreditor agreement, and provided the catch-up requirements, thus preventing the First Lien payment itself would not result in another default Lender from accurately measuring the borrower’s under the fi rst lien loan documents, such a request fi nancial performance, payments to the Second is typically accommodated. Lien Lender should be blocked. In any event, a First Lien Lender should insist upon a blockage LIEN SUBORDINATION/ right, and a Second Lien Lender should expect to ENFORCEMENT RIGHTS be blocked, at any time when the First Lien Lender is enforcing its rights and remedies with respect to Where second liens are permitted, the concept of the collateral against the borrower, as well as after lien subordination provides that the Second Lien the commencement of any type of insolvency or Lender will contractually subordinate its lien to the bankruptcy proceeding involving the borrower. lien held by the First Lien Lender. Equally as A Second Lien Lender will want certain payment important, the Second Lien Lender should agree blockages to expire after a period of time. Another not to contest the priority of the lien held by the common request is for the intercreditor agreement First Lien Lender or to join the attempt of any other to prohibit back-to-back payment blocks that have third party to challenge such liens. the effect of preventing payments to the Second As discussed briefl y above, First Lien Lenders Lien Lender indefi nitely. Most often, a Second have become more successful in conditioning their Lien Lender will argue that it should be entitled to consent to subordinate liens on the basis that such at least one interest payment every 360 days. While these requests may seem reasonable, a But just how silent should a Second First Lien Lender should remain cognizant of the Lien Lender expect to be? The fact that an impending payment block expiration could cause the First Lien Lender to take more answer is constantly evolving and aggressive action than necessary, or advisable, to varies based on the economics prevent payments to the Second Lien Lender. The of the transaction, the fi nancial First Lien Lender may be left with premature acceleration as the only available option to block strength of the borrower and the the payment to the Second Lien Lender, which general economic climate. itself could have signifi cant ramifi cations, such as diminution in and a reduction in credit terms from the borrower’s trade creditors. liens must be “silent” in certain important respects. In transactions in which a Second Lien Lender’s In general, a “silent” second lien is one in which requests for periodic payments during a default the holder of the lien agrees to refrain from are accommodated (for example, where the initiating (or joining in) any enforcement action interest payments are neither sizable nor against the borrower or the collateral and waive frequent), an indefi nite payment blockage should certain rights during an insolvency be in effect when the borrower is in payment or bankruptcy proceeding. But just how silent default and/or fi nancial covenant default under the should a Second Lien Lender expect to be? The fi rst lien loan documents. answer is constantly evolving and varies based on the economics of the transaction, the fi nancial

4 Special Report Q Winter 2008–2009

strength of the borrower and the general economic that falls somewhere between 120 and 180 days. climate. From a First Lien Lender’s perspective, a As an indicator of the rapid evolution of terms, at Second Lien Lender should be silent when it the beginning of the third quarter of 2007, it was comes to exercising creditor’s rights, whether pre- not uncommon to see remedy standstill periods as bankruptcy or following the commencement of an short as 90 days, which was just barely long insolvency proceeding. Most Second Lien enough for the First Lien Lender to react to a Lenders, however, will expect to retain certain fi nancial covenant default, much less develop and rights during the pre-bankruptcy standstill period implement a sale process. Recently, intercreditor and will strongly resist agreeing to intercreditor agreements (particularly those involving a Second provisions in which they abandon all their rights in Lien Lender that is an equity holder) have begun to bankruptcy—particularly those afforded unsecured impose upon Second Lien Lenders indefi nite creditors. We discuss the remedy standstill standstill periods, with only a limited right in favor periods and unsecured creditors rights below, and of the Second Lien Lender to accelerate its certain other bankruptcy provisions are addressed obligations (but do nothing further) if the First Lien in more detail later. Lender has done the same. The date on which a remedy standstill period Remedy Standstill Periods expires should be measured from the date the Just as a Second Lien Lender often will negotiate Second Lien Lender provides notice to the First an expiration of a payment blockage period, Lien Lender of a default under the second lien another highly negotiated issue in intercreditor documents, not from the date the default occurred. agreements is the duration of the enforcement In other words, a standstill period cannot remedy standstill period. Although most Second commence without the First Lien Lender’s Lien Lenders enter negotiations with an knowledge. No matter how long the standstill understanding that they will refrain from exercising period extends, it should also continue beyond the certain remedies with respect to pending defaults, negotiated period if the First Lien Lender is it is very rare that both parties start the process diligently pursuing its rights and remedies against with a common understanding of what remedies the borrower or a material portion of the collateral should be the subject of a standstill period and (whether such remedies are underway at the how long this period should extend. The standstill expiration of the standstill period or are later period is critical to the First Lien Lender’s ability to commenced by the First Lien Lender). Recently, work with the borrower and/or determine exit there has been pushback against the concept that strategies after a default occurs under the fi rst lien a Second Lien Lender must abandon an loan documents without any interference or enforcement proceeding if the First Lien Lender pressure from the Second Lien Lender; therefore, later decides to commence a similar action. A the First Lien Lender will attempt to extend the Second Lien Lender typically argues that if it has standstill period for as long as possible. The invested the time, effort and expense in pursuing Second Lien Lender, however, does not want to the action, it should be able to continue such action forgo its remedies for too long, as it wants to have throughout the process. While a First Lien Lender a voice in a workout. If a Second Lien Lender may be inclined to accommodate this request and must wait silently for too long, it may lose an permit the Second Lien Lender to manage the opportunity to intervene on its own behalf before enforcement action (with prior notice to the First the value of the collateral diminishes to a level that Lien Lender), any proceeds of the action received is incapable of supporting both the fi rst lien loan by the Second Lien Lender prior to payment in full and the second lien loan. of the fi rst lien obligations should be turned over to Depending on the nature of the deal, Second the First Lien Lender. Lien Lenders typically agree to a standstill period

5 VEDDERPRICE

Unsecured Creditor’s Rights may result in a Second Lien Lender’s ultimate ability to circumvent the standstill period and other While it is typical for a Second Lien Lender to be provisions of the intercreditor agreement. In prohibited from pursuing its rights as a secured particular, a Second Lien Lender that maintains its creditor during the standstill period and in rights under the intercreditor bankruptcy, intercreditor agreements usually allow agreement could join with other unsecured a Second Lien Lender to pursue certain unsecured creditors and fi le an involuntary petition against the borrower, pushing the borrower into bankruptcy [A] First Lien Lender should be and effectively halting any enforcement action that wary that allowing a Second Lien the First Lien Lender has commenced. Similarly, a Second Lien Lender that retains a right to fi le Lender to retain certain unsecured motions and make objections as an unsecured creditor rights may result in a creditor in bankruptcy may be able to circumvent the pre-negotiated agreement that the First Lien Second Lien Lender’s ultimate Lender will control the process in bankruptcy. ability to circumvent the standstill Thus, it is important to evaluate the various period and other provisions of the unsecured creditor rights a Second Lien Lender seeks to retain in light of the terms of the intercreditor agreement. intercreditor agreement. Instead of granting a Second Lien Lender’s request for unfettered unsecured creditor rights, those rights that are left creditor rights that comply with the terms and intact should be subject to the terms and conditions of the intercreditor agreement itself. conditions negotiated in the intercreditor This is an element of intercreditor agreements that agreement and, in particular, the standstill period. has remained largely unchanged in recent months. A Second Lien Lender will argue that it should not Release of Collateral be expected to give up any rights it would have as an unsecured mezzanine lender by virtue of In order to afford the First Lien Lender the greatest receiving liens to secure its collateral. Examples fl exibility in managing the borrower and the of such actions include the right to request collateral, the intercreditor agreement should dismissal or conversion of the borrower’s identify certain pre-established “release events” bankruptcy case, the right to vote against and where a Second Lien Lender’s lien on shared object to plan confi rmation or the right to propose collateral is released without its consent. Such a creditor’s plan in bankruptcy. When evaluating “release events” typically include these requests, a First Lien Lender should (1) prior to an insolvency proceeding, consider what rights would be limited if it was (a) a release that is permitted negotiating an intercreditor agreement with an by the terms of the fi rst lien unsecured mezzanine lender. For example, it is documents; not uncommon for an intercreditor agreement with an unsecured lender to impose upon that lender a (b) a release that is consented standstill period with respect to exercising rights to by the First Lien Lender available to it under contract or at law. following the occurrence of an When evaluating a request to preserve event of default under the fi rst unsecured creditor rights, a First Lien Lender lien loan documents; and should be wary that allowing a Second Lien (c) a release that occurs in Lender to retain certain unsecured creditor rights connection with the First Lien

6 Special Report Q Winter 2008–2009

Lender’s exercise of rights and and thwart any possible interference by a Second remedies against collateral; and Lien Lender, the intercreditor agreement should (2) after an insolvency proceeding, a provide for an irrevocable power of attorney release in accordance with allowing the First Lien Lender to fi le any releases in the event that the Second Lien Lender refuses to (a) a sale pursuant to a confi rmed abide by the terms of the intercreditor agreement. plan of reorganization or ; MODIFICATIONS TO (b) a sale in a bankruptcy CREDIT AGREEMENTS proceeding of one or more assets, free and clear Given that the terms of an intercreditor agreement of all liens, claims and are negotiated based on the “closing day” terms of encumbrances (commonly the fi rst lien loan documents and second lien loan referred to as a “Section 363 documents, and the rights of each lender Sale”); and thereunder, both parties will seek to restrict the (c) an order by the bankruptcy other party from subsequently amending its loan court to vacate the automatic documents to circumvent the restrictions set forth stay under Section 362 of the in the intercreditor agreement. Bankruptcy Code to allow the Most Second Lien Lenders will desire to limit the First Lien Lender to exercise its total outstanding indebtedness to the First Lien enforcement rights against the Lender, since the First Lien Lender enjoys the collateral. benefi t of both lien and payment priority (commonly referred to as the “Senior Debt Cap”). The Senior A common request of Second Lien Lenders is to Debt Cap typically is the sum of (a) the maximum expand the pre-consent to dispositions that are amount of fi rst lien revolving and term loan credit permitted under the fi rst lien documents to require facilities plus (b) a “cushion” of approximately 10- that such dispositions also be permitted under the 15% above that total amount prior to any second lien loan documents. A First Lien Lender insolvency or bankruptcy proceeding involving the should be aware that this request creates a borrower plus (c) an additional “cushion” of disguised consent right in favor of the Second Lien approximately 10% to provide -in- Lender that could interfere with the First Lien possession (“DIP”) fi nancing after any insolvency Lender’s exercise of rights and remedies against or bankruptcy proceeding involving the borrower the collateral. Similarly, a request by a Second plus (d) indebtedness related to hedging Lien Lender to pre-consent only to dispositions agreements, cash or other related that are made when an event of default under the obligations plus (e) interest, fees, costs, charges, second lien loan documents does not exist expenses, indemnities and other amounts payable effectively forecloses the First Lien Lender’s ability pursuant to the terms of the fi rst lien documents, to realize on its collateral during an event of including protective advances in bankruptcy. A default. Any concerns a Second Lien Lender has First Lien Lender will often accommodate the about providing a “blanket” consent to dispositions request of a Second Lien Lender to reduce the outside of bankruptcy or an event of default under Senior Debt Cap by any permanent reductions of the fi rst lien loan documents can be satisfactorily revolving loan commitments and principal addressed by limiting the disposition terms under payments on term loan debt, which prevents the the fi rst lien loan documents to those in effect on “reloading” of any credit facilities. the effective date of the intercreditor agreement. Whether the First Lien Lender will suffer To further protect a First Lien Lender’s exercise consequences if it exceeds the Senior Debt Cap of rights and remedies with respect to a borrower

7 VEDDERPRICE

amount depends on the nature of the deal. A Since the most recent second lien loans typically Second Lien Lender may request that the First bear interest at a fi xed rate, fl exibility for the Lien Lender agree that any outstanding Second Lien Lender to similarly impose a fl oor indebtedness in excess of the Senior Debt Cap usually is not required (but should be granted if the will be subordinate to, and paid out after, the second lien obligations do not have a fi xed interest second lien obligations. If a First Lien Lender rate). It is also customary for the Second Lien agrees to this restriction, it must carefully evaluate Lenders and the First Lien Lenders to agree in the two elements of the restriction. First, the Senior intercreditor agreement not to amend the loan Debt Cap must be large enough to accommodate documents by changing the repayment obligations the future of the credit facility. For example, if the of the borrower in a way that would accelerate the borrower has acquisitions planned that will require scheduled dates of permitted principal payments an increase in senior loans, that increase should on the second lien loans, or extend the be taken into account, in addition to the general date of the fi rst lien loan. 10-15% cushion for additional debt. Second, the The First Lien Lender should maintain its ability First Lien Lender must restrict the amount of the to amend the fi rst lien loan documents in order to Second Lien Lender’s obligations to that (1) shorten the fi nal maturity; (2) accelerate or contemplated on the date of the intercreditor change the amount of payments (in a non-default situation); (3) release or implement reserves; The First Lien Lender must (4) change the borrowing base or eligibility criteria maintain this fl exibility with respect which constitute the borrowing base (if the fi rst lien loan documents include a borrowing base); to its loan documents to protect (5) increase or add fees; and (6) waive a payment itself from future changes or events default. The First Lien Lender must maintain this fl exibility with respect to its loan documents to that impact the collateral or the protect itself from future changes or events that borrower’s performance under the impact the collateral or the borrower’s performance credit facility. under the credit facility. On the other hand, Second Lien Lenders are usually prohibited from modifying their loan documents in any manner agreement and not simply rely on the total adverse to the First Lien Lenders or in any respect leverage covenant in the fi rst lien loan documents that makes the provisions more restrictive or more as a debt governor. This planning is essential to burdensome on the borrower. make sure that any fi rst lien obligations in excess of the Senior Debt Cap are not subordinate to an RIGHTS IN BANKRUPTCY undefi ned amount of second lien obligations. As noted above, the bankruptcy provisions of the Typically, the parties to an intercreditor intercreditor agreement are likely to be highly agreement agree to mutually limit increases to negotiated, particularly when dealing with a interest rates under the fi rst and second lien loan Second Lien Lender with bargaining power. Giving documents. The range agreed to is usually a Second Lien Lender greater rights in bankruptcy, between 200 to 300 basis points. Given the and thus the opportunity to be “less silent,” is an recent events in the interest rate markets, a First accommodation the First Lien Lender should Lien Lender should ensure that it maintains the carefully scrutinize. In a bankruptcy context, right to impose an interest rate “fl oor” without accommodations that seemed reasonable at the requiring the Second Lien Lender’s consent, outset of a lending relationship can suddenly turn whether that fl oor is applied to the applicable destructive. In an insolvency or bankruptcy margin of interest or to the underlying rate indices.

8 Special Report Q Winter 2008–2009

proceeding, the First Lien Lender will expect the approved by the court), in any case so Second Lien Lender to allow it to work with the long as certain conditions are met: borrower to restructure the debt free from any (a) the First Lien Lender must retain interference in an attempt to maximize repayment its pre-petition lien priority status of the borrower’s obligations to the First Lien (subordinated to the DIP lender); Lender. The Second Lien Lender, however, has a (b) the Second Lien Lender must competing interest in maximizing repayment of the receive a replacement lien on borrower’s subordinated obligations to it. While post-petition assets to the same the enforceability of certain pre-bankruptcy extent as, but junior to, the liens waivers is not entirely clear because few reported of the DIP lender; decisions have addressed subordination issues (and those that do exist tend to have contradictory (c) the aggregate principal amount results), the First Lien Lender typically will require of loans and letter-of-credit in the intercreditor agreement that the Second obligations, together with the Lien Lender waive and consent to certain outstanding pre-petition First bankruptcy provisions including, at a minimum, the Lien Lender debt, does not following: (1) debtor-in-possession fi nancing (“DIP exceed the negotiated Senior Financing”); (2) use of cash collateral; Debt Cap; and (3) adequate protection; and (4) sales of (d) the terms of the DIP Financing collateral.1 are subject to the intercreditor agreement. DIP Financing; Use of Cash Collateral The Second Lien Lender may require that the Once in bankruptcy and attempting to reorganize, DIP Financing be on “commercially reasonable a borrower often will need additional fi nancing to terms” as a condition to consenting in advance. A continue its operations. The cash to fi ll this gap First Lien Lender should instead consider adding a will come in the form of a DIP Financing. The condition that requires that the bankruptcy court lenders providing the DIP Financing receive a fi nd the DIP Financing to have been “negotiated at super priority lien, which will prime the liens held arms’ length and in good faith.” This language is by both the First Lien Lenders and the Second found in most court orders approving DIP Lien Lenders. The First Lien Lender often desires Financing. A court does not use a “commercially to provide the DIP Financing and will require that reasonable” standard when evaluating a proposal the Second Lien Lender for DIP Financing, nor is there a readily available market against which to judge the commercial (1) consent in advance (and not object) to reasonableness of the DIP Financing. The any such DIP Financing, or the use of “commercially reasonable” merely provides the cash collateral that has been consented Second Lien Lender with an opportunity to object to by the First Lien Lender, and to DIP Financing. (2) agree to subordinate its liens to the Another common request by the Second Lien prior liens securing the DIP Financing Lender is to include the amount of any “carve outs” (and any cash collateral or “carve outs” in the calculation of whether the Senior Debt Cap has been exceeded. Depending on the size of the 1 For example, see In re 203 North LaSalle Street Partnership, 246 B.R. borrower and the state it is in when entering 325 (Bankr. N.D. Ill. 2000) (holding that a voting provision in the applicable subordination agreement whereby the second lien lender waived its voting bankruptcy, the carve out for professional fees rights in bankruptcy was unenforceable); and In re Aerosol Packaging, LLC, could be signifi cant, and including such fees in the 362 B.R. 43 (Bankr. N.D. Ga. 2006) (upholding a provision whereby a junior Senior Debt Cap calculation could consume the creditor waived its voting rights in bankruptcy and specifi cally rejected the courts reasoning in the In re 203 North LaSalle Street Partnership decision). entire post-bankruptcy “cushion” intended for

9 VEDDERPRICE

principal increases. Often, the best solution is to on the same collateral securing either the First allow the Second Lien Lender to preserve its Lien Lender debt or any DIP Financing provided by objection right with respect to this discrete issue the First Lien Lenders that is senior to the lien and address it in the context of the bankruptcy granted to the Second Lien Lender; and (3) the court. replacement lien granted to the Second Lien A Second Lien Lender may seek to add, as an Lenders must be subordinate to all liens securing additional consent to the pre-negotiated the First Lien Lender debt or any DIP Financing as conditions, a requirement that the order approving refl ected in the intercreditor agreement. the DIP Financing not describe or require a plan of A Second Lien Lender additionally may request reorganization. This prevents a First Lien Lender the right to receive adequate protection payments from forcing the Second Lien Lender to give up in cash. However, the First Lien Lender could be rights otherwise available to it in the intercreditor disadvantaged, as allowing additional cash agreement by coupling DIP Financing and a plan payments in bankruptcy will affect the borrower’s of reorganization together. Depending on what liquidity. If the First Lien Lender agrees to this rights the Second Lien Lender has elsewhere in request, two aspects of the intercreditor agreement the intercreditor agreement regarding a plan of must be modifi ed accordingly. First, the Senior reorganization, a First Lien Lender may agree to Debt Cap should increase by an amount equal to this request. In any event, however, the First Lien all adequate protection payments paid to the Lender should seek to limit the Second Lien Second Lien Lender. Second, the intercreditor Lender’s rights to only the right to object to the DIP agreement must include a “clawback” provision Financing on the basis that it also includes a plan providing that, if the borrower exits bankruptcy of reorganization. without paying the First Lien Lender’s obligations in full, any adequate protection payments received Adequate Protection by the Second Lien Lender must be paid over to the First Lien Lender, to the extent of the shortfall. Secured creditors generally desire to obtain adequate protection by requesting additional or Sale of Collateral (§363 Sale) substitute collateral to protect against declines in the value of the collateral after the commencement It is typical for the First Lien Lender to require that of an insolvency or bankruptcy proceeding. A the Second Lien Lender waive any rights to object Second Lien Lender should expect to waive any to a Section 363 Sale. This waiver is rarely right to dispute actions taken by First Lien Lenders objectionable to a Second Lien Lender because to seek adequate protection with respect to the additional protections with respect to the collateral securing the First Lien Lender reasonableness of any Section 363 Sale are obligations. In return for waiving this right, the automatically built into the bankruptcy process, Second Lien Lender may ask to retain the right to including oversight from a creditors’ committee and request and receive adequate protection with required approval from both the U.S. Trustee and respect to its own obligations in connection with the bankruptcy court itself. However, it should be any DIP Financing or use of cash collateral. A noted that the recent decision by the Ninth Circuit First Lien Lender often will accommodate this Bankruptcy Appellate Panel in Clear Channel request so long as certain conditions are met, Outdoor, Inc. v. Knupfer (In re PW, LLC), including the following: (1) any such adequate No. 07-1176 (Bankr. 9th Cir. July 18, 2008), makes protection is limited to the Second Lien Lender it necessary for the Second Lien Lender to refrain receiving a replacement lien on additional or from objecting to such sale and expressly provide replacement post-petition collateral; (2) the First advance consent to any such disposition free and Lien Lenders must also receive a replacement lien clear of any liens or other claims under

10 Special Report Q Winter 2008–2009

Section 363 of the Bankruptcy Code or any other CONCLUSION similar bankruptcy law. Clear Channel held that Section 363(f) of the Bankruptcy Code does not The evolution of “market” terms will continue for permit a senior secured creditor to credit bid its second lien loans, particularly in light of the rapidly debt and purchase estate property free and clear changing fi nancial markets. Second lien loans of valid, nonconsenting junior liens on the continue to be attractive options for collateral, notwithstanding a prior agreement from , DIP Financings, exit fi nancings the junior creditor to refrain from objecting to such and restructurings. As mezzanine fi nancing sale. A First Lien Lender should ensure that its becomes more costly, whether due to tightening of “Section 363 Sale” waiver clause also includes a liquidity in the market or by virtue of pure supply- consent (or deemed consent) by the Second Lien and-demand economics, second lien loans may Lender to such sale. again return to their former position as the prominent subordinated loan product. For The X-Clause transactions in which second liens are part of the capital structure, the tables appear to be turning in A provision that has been appearing more favor of the First Lien Lenders on terms. frequently in intercreditor agreements addresses the Second Lien Lender’s rights to receive and Authors: Dana S. Armagno, Marie H. Godush, Kathryn L. retain debt or equity securities issued pursuant to Stevens and Michael M. Eidelman a plan of reorganization by the borrower. This has Editor: Michael A. Nemeroff become known as the “X-Clause” because it constitutes an exception to the general rule of lien If you have any questions or wish to discuss this subordination that requires that any and all First topic further, please contact Dana S. Armagno at Lien Lender debt must be paid in full, in cash, 312-609-7543, [email protected], before anything of value is distributed to the Michael A. Nemeroff at 312-609-7858, Second Lien Lender with respect to the second [email protected], any member of our lien obligations. Where a Second Lien Lender is Finance and Transactions Group listed on the last more aggressive or has more leverage, it may be page or your Vedder Price contact attorney. able to negotiate permission to receive debt securities issued under a plan of reorganization or similar plan secured by liens on certain collateral as long as (1) the First Lien Lender also receives such debt securities secured by liens on the same collateral and (2) the liens received by the Second Lien Lender constitute liens that are subordinated to those held by the First Lien Lender on the same terms as provided in the intercreditor agreement. However, the concept of debt subordination should continue to apply with respect to the receipt by a Second Lien Lender of equity securities under an organization plan, requiring that any such equity securities be turned over to the First Lien Lender until all the First Lien Lender debt is paid in full.

11 VEDDERPRICE Special Report Q Winter 2008–2009

FEDERAL TAX NOTICE: Treasury Regulations require us to inform you that any federal tax advice contained herein is not intended or written to be used, and cannot be used by any person or entity, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

About Vedder Price Dean N. Gerber Stephanie K. Hor-Chen VEDDERPRICE ® Vedder Price P.C. is a national business- John R. Obiala Earnest G. Gregory oriented law fi rm with over 260 attorneys in Jonathan H. Bogaard Eliza Hommel Peterson 222 NORTH LASALLE STREET Chicago, New York and Washington, D.C. William A. Kummerer Bridget A. Adaska Michael G. Beemer Dozie Okpalaobieri CHICAGO, ILLINOIS 60601 Robert J. Moran David A. Bowen The Finance and Transactions Group 312-609-7500 FAX: 312-609-5005 Dalius F. Vasys Laura T. Guest The Finance and Transactions Group of Daniel T. Sherlock Timothy L. Cox Vedder Price actively represents publicly held Douglas M. Hambleton Rachael N Harris 1633 BROADWAY, 47th FLOOR and private , fi nanciers, leveraged Timothy W. O’Donnell Benjamin J. Schmidt NEW YORK, NEW YORK 10019 buy-out fi rms, private equity funds, venture Lane R. Moyer Courtney W. Dean capitalists, lenders, and related parties in a 212-407-7700 FAX: 212-407-7799 Jeffrey C. Davis broad range of matters, including mergers Michael M. Eidelman New York and acquisitions; equity and debt fi nancing; Geoffrey R. Kass Steven R. Berger 875 15th STREET NW, SUITE 725 mezzanine fi nancing; venture capital; private William J. Bettman Denise L. Blau WASHINGTON, D.C. 20005 equity investments; and related transactions. Paul R. Hoffman John E. Bradley 202-312-3320 FAX: 202-312-3322 John T. Blatchford Michael J. Edelman This Special Report is intended to keep Dana S. Armagno John I. Karesh clients and interested parties generally N. Paul Coyle Michael C. Nissim www.vedderprice.com informed about issues related to commercial Matthew T. O’Connor Francis X. Nolan III fi nance. It is not a substitute for professional Peter J. Kelly Stewart Reifl er advice. For purposes of the New York State Ernest W. Torain, Jr. Michael L. Schein Bar Rules, this report may be considered Jennifer Durham King Ronald Scheinberg ATTORNEY ADVERTISING. Prior results do Kathryn L. Stevens Donald A. Wassall not guarantee a similar outcome. Joseph H. Kye Amy S. Berns Adam S. Lewis Daniel J. Barlin © 2008 Vedder Price P.C. Reproduction of Vivek G. Bhatt Jennifer A. Johnson this report is permitted only with credit to Eric J. Rietz Vedder Price. Allen J. Gable Washington, D.C. David P. Kaminski Principal Members of the Finance Douglas Ochs Adler Nicholas S. Harned and Transactions Group Caryl Ben Basat Dennis P. Lindell Edward K. Gross Chicago James W. Morrissey David M. Hernandez Michael A. Nemeroff (Chair) Venu V. Talanki Theresa Mary Peyton Robert J. Stucker John M. Gall Philip M. Livingston Thomas P. Desmond Marie H. Godush Erin Spry Staton John T. McEnroe Ryan O. Lawlor Daniel O’Rourke Charles W. Murphy Guy E. Snyder David J. Borkon Douglas J. Lipke Nathaniel A. Tiffany Thomas E. Schnur W. Tyler Adkerson