A Primer on Second Lien Term Loan Financings By Neil Cummings and Kirk A. Davenport

ne of the more noticeable developments in can protect their interests in the collateral by requiring the debt markets in the last year has been second lien lenders to agree to a “silent second” lien. Othe exponential increase in the number of Second lien lenders can often be persuaded to second lien fi nancings in the senior bank loan mar- agree to this arrangement because a silent second ket. Standard & Poor’s/Leveraged Commentary & lien is better than no lien at all. In addition, under Data Team reports that second lien fi nancings raised the intercreditor agreement, in most deals, the more than $7.8 billion in the fi rst seven months of second lien lenders expressly reserve all of the 2004 alone, compared with about $3.2 billion for all rights of an unsecured creditor, subject to some of 2003. important exceptions. In this article, we discuss second lien term loans All of this sounds very simple, and fi rst and second marketed for sale in the institutional loan market, lien investors may be tempted to ask why it takes with a goal of providing both an overview of the pages of heavily negotiated intercreditor terms to product and an understanding of some of the key document a silent second lien. The answer is that business and legal issues that are often at issue. a “silent second” lien can span a range from com- In a second lien loan transaction, the second lien pletely silent to fairly quiet, and where the volume lenders hold a second priority security interest on the control is ultimately set varies from deal to deal, assets of the borrower. Their security interest ranks sometimes significantly. A standard package of second to the liens in those assets securing the fi rst intercreditor terms has yet to emerge in the second priority lien debt. In the event of a foreclosure on the lien term loan market, although a consensus is de- shared collateral that secures the fi rst and second veloping on many of the key issues and how they lien debt, the fi rst lien creditors will be entitled to ought to be resolved. be paid in full from the enforcement proceeds before Before we discuss those issues, it is helpful to re- any payments are made to the second lien lenders view some key background information since that out of those proceeds. information is important to understanding what is Typically, the fi rst priority lien debt is a senior at stake in the intercreditor negotiations. working capital facility, usually consisting of a revolving loan facility, sometimes coupled with a term loan facility. Senior working capital lenders will Background generally insist on holding a fi rst priority lien on the In a bankruptcy proceeding, secured creditors borrower’s assets; however, in a number of transac- hold a series of significant rights that unsecured tions, they have been willing to permit second lien creditors don’t enjoy. As a result, secured credi- lenders to hold a lien on the borrower’s assets. tors have significantly higher recovery rates in There are a few reasons for this. First, the proceeds bankruptcies and other reorganizations than of the second lien loans may be used to prepay the unsecured creditors. fi rst lien debt or to reduce the amount of fi rst lien debt otherwise needed. In addition, there may not be a market for the borrower to borrow the funds it needs Neil Cummings is a Partner in the Los Angeles offi ce of Latham & Watkins on a fi rst lien basis. As a result, allowing junior liens LLP. He can be reached at [email protected]. on their collateral may be the price that the fi rst lien lenders have to pay to make a deal happen. Finally, Kirk A. Davenport is a Partner in the New York offi ce of Latham & Wat- fi rst lien lenders are increasingly comfortable that they kins LLP. He can be reached at [email protected].

SEPTEMBER–OCTOBER 2004 COMMERCIAL LENDING REVIEW 11 Second Lien Term Loan Financings

Priority Vis-À-Vis the Trade tutions of collateral or the grant of a priming lien and Other Unsecured Creditors on collateral to secure a debtor-in possession, or Under the bankruptcy code, creditors’ claims DIP, fi nancing). Upon request to the bankruptcy generally can be divided into three basic classes: court, secured creditors are entitled to assurance secured claims, priority unsecured claims and that their collateral is adequately protected if general unsecured claims. A second lien creditor’s there is a serious risk of its diminution in value. claim is treated as a secured claim to the extent of The “adequate protection” may take the form of a the value of its interest in the collateral. As a result, court-ordered grant of additional or substitute col- a creditor that is undersecured (that is, the value of lateral or the provision of periodic cash payments its collateral is less than the amount of its prepeti- to the secured creditor. Adequate protection is an tion claim) will hold both secured and unsecured extremely valuable right for a secured creditor. claims. Under the bankruptcy code, secured claims are entitled to receive value equal to the full value Harder to Be Crammed Down of their interest in the collateral before any value The bankruptcy code gives the creditors in each class is given to holders of unsecured claims, and any the right to vote on any proposed plan of reorgani- priority unsecured claims are entitled to receive zation. In certain circumstances, however, a plan of the full value of their reorganization can be con- claims before any gen- fi rmed over the objections eral unsecured claims of a particular class of receive any value. To the A standard package of intercreditor terms creditors. A class of credi- extent a secured creditor has yet to emerge in the second lien term tors that is forced to accept is undersecured, that un- loan market. the terms of a plan that it dersecured creditor will voted against is said to be share ratably with other “crammed down.” Under general unsecured credi- the tests applied under the tors (including trade creditors) in the amount, if bankruptcy code, it is generally much harder for a any, remaining after repayment in full of both class of secured creditors to be crammed down in secured claims and priority unsecured claims. a bankruptcy than a class of unsecured creditors, which can give a secured creditor signifi cantly more Post-Petition Interest leverage in the plan or restructuring negotiations. A secured creditor is entitled to post-petition in- terest under the Bankruptcy Code to the extent the value of its interest in the collateral securing Structuring Issues its claim is greater than the amount of its pre- With that background discussion behind us, we will bankruptcy claim. An undersecured creditor is now turn to a series of specifi c questions about how not entitled to post-petition interest. The amount to structure a second lien term loan transaction. of post-petition interest can be significant in prac- tice given that the bankruptcy proceedings may What Makes a “Silent Second” Silent? run for several years. A lien only becomes “silent” if the holder of the lien contractually agrees not to exercise some or all of Adequate Protection Rights the particular rights that it obtained by becoming a Under the bankruptcy code, a secured creditor has secured creditor. In a second lien term loan fi nancing, the right to be protected against declines in the the terms of the “silent second” are usually set out value of its interest in the collateral following the in an intercreditor agreement. There are usually four date of the bankruptcy fi ling. This is a very broad key elements to the intercreditor agreement: right and entitles a secured creditor to a voice in Prohibitions (or limitations) on the right of the any actions taken in a bankruptcy proceeding that second lien holders to take enforcement actions, could affect the value of its collateral (including with respect to their liens (possibly subject to the use of cash collateral, sales of collateral, substi- time or other limitations)

12 COMMERCIAL LENDING REVIEW SEPTEMBER–OCTOBER 2004 Second Lien Term Loan Financings

Agreements by the holders of second liens not commonly found in intercreditor agreements in the to challenge enforcement or foreclosure actions second lien term loan market: taken by the holders of the fi rst liens (possibly Adequate protection waivers subject to time or other limitations) Advance consents to use of cash collateral Prohibitions on the right of the second lien hold- Advance consents to sales of collateral ers to challenge the validity or priority of the Advance consents to DIP fi nancings fi rst liens Waiver of the Right to Oppose Adequate Protec- Waivers of (or limitations on) other secured tion for the First Lien Debt. Second lien term lenders creditor rights by the holders of second liens typically waive any right to dispute actions taken by the fi rst lien lenders to seek adequate protection with What Secured Creditor Rights Do the Second respect to the collateral securing the fi rst lien debt. Lien Lenders Typically Waive During the This waiver is not particularly controversial and is Period Before a Bankruptcy Filing? not usually subject to any time limitation. In a second lien term loan deal, the second lien Waiver of the Right to Seek Adequate Protection. is often more in the nature of a “quiet second” In some cases, the term loan lenders will waive their than a silent second. Generally, second lien term adequate protection rights for so long as any fi rst lenders will only agree to lien debt is outstanding. refrain from exercising In most cases, however, their secured creditor there is strong resistance rights for a limited pe- Adequate protection is an extremely by institutional term riod of time, typically 90 valuable right for a secured creditor. loan lenders to agree to to 180 days. This period any blanket adequate of time is often referred protection waivers. In to as a “fish-or-cut-bait” most recent deals, the or “standstill” period. At the end of the standstill term loan lenders have prevailed on this point, period, the first lien lenders lose their monopoly and blanket adequate protection waivers are in- on the exercise of secured creditor remedies. A few creasingly rare. deals have taken an even more aggressive line and Advance Consents. Second lien term lenders typi- include a “use-it-or-lose-it” provision that forces cally give an advance consent to the following: the first lien lenders to make an election of rem- Any use of cash collateral approved by the edies within the prescribed time period or forfeit fi rst lien debt (effectively waiving their right to the right to take remedial action in the future. In oppose the borrower’s proposed use of cash col- some of those deals, the impact of those provisions lateral on adequate protection grounds) on the first lien lenders was mitigated by provid- Any court-approved asset sale that is also ap- ing that an affirmative decision by the first lien proved by the fi rst lien lenders as long as the lenders not to exercise remedies constitutes the second liens attach to the proceeds of the sale in required election of remedies. Second lien term accordance with the lien priorities agreed to in lenders typically waive their right to challenge the intercreditor agreement the validity, enforceability or priority of the first DIP fi nancings (which may take the form of an liens, sometimes (but often not) in exchange for a unconditional consent or may be conditioned on reciprocal waiver by the first lien lenders. (1) a dollar cap on the amount of the DIP fi nanc- ing or (2) a requirement that the liens securing What Secured Creditor Rights the DIP fi nancing rank prior or equal to the liens Do the Second Lien Debt Holders securing the fi rst lien debt to avoid DIP liens be- Typically Waive in a Bankruptcy? ing layered between the fi rst and second liens) The short answer is all of the same rights they waive before bankruptcy (as discussed above), plus some Are Intercreditor Agreements Enforceable? others that arise as a result of the bankruptcy. The Courts are generally willing to enforce inter- following post-bankruptcy waivers and consents are creditor agreements between a borrower’s

SEPTEMBER–OCTOBER 2004 COMMERCIAL LENDING REVIEW 13 Second Lien Term Loan Financings creditors, even when the borrower is in bank- plan discussions. Furthermore, unsecured credi- ruptcy. The Bankruptcy Code specifically states tors almost never agree to limit their voting rights that a subordination agreement is as enforceable in a plan, and including such a provision in an in a bankruptcy as it is intercreditor agreement outside of bankruptcy. could cause the silent As a general matter, an second lien creditor to intercreditor agreement Second lien term loan fi nancings … allow have significantly less containing the types of borrowers to tap capital that might not bargaining power than provisions discussed an unsecured creditor in above should be enforce- otherwise be available to them. plan negotiations. These able under state law, factors may explain why both before and during a restrictions on the right bankruptcy. In practice, most bankruptcy courts to vote for or against particular plans of reorga- will not police compliance with every aspect of nization are strongly resisted by second lien term the advance waivers and consents contained in loan lenders. an intercreditor agreement, but the final plan of reorganization will usually give effect to that Who Controls Releases of Collateral? agreement’s priority waterfall provisions by treat- Pre-Bankruptcy. Generally, the second lien loan ing first and second lien creditors as separate documents provide for an automatic release of the classes for plan purposes. If the first lien credi- second liens on any collateral upon a sale of that tors want specifically to enforce the intercreditor collateral in compliance with the asset sale covenant agreement, they generally will need to make their in the second lien loan agreement. Other collateral case in state court in the state selected as the gov- releases typically require the consent of the second erning law in the intercreditor agreement. lien lenders. During Bankruptcy. During a bankruptcy, the Does a “Silent Second” Lien Creditor Ever End second lien lenders typically agree not to object up Worse off Than an Unsecured Creditor? to any court-ordered asset sale approved by the Typically, an intercreditor agreement expressly first lien creditors as long as the second liens states that, both before and during a bankruptcy, attach to the proceeds of the sale in accordance the second lien lenders can take any actions and with the lien priorities agreed to in the intercredi- exercise any rights that they would have had if they tor agreement. In light of the bankruptcy code were unsecured creditors, except any rights they restrictions on the sale of assets in bankruptcy, expressly waived in the intercreditor agreement, second lien term lenders tend to be comfortable such as with respect to adequate protection, use of with this approach. cash collateral, sales of collateral, DIP fi nancings and the right to challenge the fi rst liens. We think Do Second Lien Holders Get the Same these limitations are appropriate. We have seen fi rst Collateral As First Lien Holders? lien creditors go even further, however, and request In general, the second lien collateral will not advance agreements by the second lien lenders on include any assets excluded from the fi rst lien how they will vote on a plan of reorganization. collateral. There will tend to be very few (if any) These voting agreements are more controversial differences between the collateral securing the fi rst and may not be enforceable. lien debt and the collateral securing second lien The right to vote on a plan of reorganization term loans. If the fi rst lien debt is an asset-based provides significant protections for a secured lending facility, sometimes the fi rst lien lenders creditor. First and second lien creditors have very will take a fi rst lien on the current assets of the different interests, and they frequently (and often borrower, such as receivables and inventory, and strongly) disagree on the merits of a proposed a second lien on the borrower’s long-lived assets, plan. Second lien lenders that agree to voting such as equipment. The second lien term loans in restrictions may lose significant traction in the turn may be secured by a fi rst priority lien on the

14 COMMERCIAL LENDING REVIEW SEPTEMBER–OCTOBER 2004 Second Lien Term Loan Financings borrower’s long-lived assets and a second priority Retirement Income Security Act of 1974] liens) lien on its current assets. These types of crisscross In some deals, the parties may agree to include lien arrangements can simplify negotiation of the other liens in the defi nition of permitted prior liens. intercreditor terms since the fi rst lien lenders will If the obligations secured by permitted prior liens often have to live with the subordination terms are material, however, the agent bank may fi nd it they bargain for on their fi rst lien collateral when much harder to market and/or syndicate the trans- it comes to their second lien collateral. action successfully.

Are There Any Limits on the Amount Can the Second Lien Lenders of Future First and Second Lien Debt? Purchase the First Lien Obligations? The typical covenant package in a second lien In some second lien fi nancings, the fi rst lien creditors deal will fix the maximum principal amount of have given second lien lenders an option to pur- first lien debt that may be incurred (usually based chase the fi rst lien obligations. The exercise price is on the amount of first lien commitments at the generally the par value of the outstanding fi rst lien closing, plus a “cushion”). The typical second lien debt plus accrued interest (excluding any amounts covenant package will also cap the borrower’s payable as prepayment or acceleration penalties or ability to incur additional second lien debt. The premiums). Usually, the option can be exercised cap on future second lien debt is usually based on during an agreed time period starting on the date a maximum leverage ratio or other financial test on which the borrower fi les for bankruptcy and/or although it could be expressed as a dollar cap. the fi rst lien creditors take any action to foreclose on their collateral. Some second lien lenders view the Are There Other “Permitted Prior Liens”? purchase option as a “must-have” provision. First The term “second lien debt” is not intended lien creditors generally view the purchase option as as an absolute statement of the priority of the acceptable since, if exercised, it allows them to exit liens securing second lien debt. In fact, the liens a troubled credit at par. securing second lien debt are junior both to the There is some value to a purchase option for the liens securing the first lien debt and to certain second lien lenders because, once it is exercised, the other liens, usually called “permitted prior liens,” second lien lenders will no longer be subject to any which are permitted to rank ahead of the second of the lien subordination arrangements discussed liens (and often the first liens) under the terms of above and will be free to exercise all of the rights the security documents. The payment of creditors of a secured creditor. As a result, the second lien secured by permitted prior liens generally will lenders will have increased leverage in the plan or be incorporated into the priority waterfall provi- out-of-court restructuring negotiations that may sions for distributions of collateral sale proceeds translate into a higher net recovery for the second contained in the intercreditor agreement. lien lenders. Many second lien lenders place less As a general rule, permitted prior liens fall into emphasis on this purchase option, however, since, four categories: in their view, in most bankruptcies, fi rst lien lenders Liens securing the fi rst lien debt and all related generally will agree at the time to sell their debt to fi rst lien obligations the second lien lenders at par. Liens that predate the second liens (which, in some deals, may include liens that the borrower Are Two Sets of Security Documents Needed? “inherits” if, for example, it acquires assets in the The 1991 case of In re Ionosphere Clubs, Inc.1 has future that are subject to liens) stirred some debate as to whether the first and Liens securing a maximum amount of purchase second liens can be granted in a single set of se- money debt curity documents (containing separate grants of Liens that are not voluntarily granted by the security interests for the first and second liens) borrower but arise by operation of law and are rather than in separate sets of security documents. entitled by law to priority over the second liens Some first lien lenders are concerned that they (for example, certain tax and ERISA [Employee may prejudice their right to post-petition interest

SEPTEMBER–OCTOBER 2004 COMMERCIAL LENDING REVIEW 15 Second Lien Term Loan Financings unless the first and second liens have completely and typically attractively priced, investment for second separate security documents. lien lenders, and they allow borrowers to tap capital We believe that, if properly documented, a single set that might not otherwise be available to them. In many of security documents should work to ensure that the cases, the availability of second lien capital may make fi rst and second lien creditors hold separate secured the difference for a borrower between being able to do claims. The prevailing sentiment in the second lien a deal and being denied access to needed capital. The term loan market, however, has generally been to take intercreditor terms that govern second lien fi nancings the more conservative approach and to document the have yet to be defi ned by market conventions and vary second liens in a separate set of security documents that from deal to deal. Over time, though, we predict that substantively mirror the fi rst lien security documents. market terms for the intercreditor provisions in these This tends not to be controversial among borrowers deals will emerge in much the same way that custom- since the incremental cost of creating a second set of con- ary subordination terms have developed over time in forming security documents tends to be fairly small. We subordinated debt deals. For now, though, it remains expect this practice to continue in the second lien term important for investors to read the small print in the loan market at least until the Ionosphere decision has intercreditor agreement to understand the terms of the been revisited and its holding clarifi ed by the courts. debt they are purchasing.

Conclusion Endnote Second lien term loan fi nancings are here to stay, at least 1 In re Ionosphere Clubs, Inc., 134 BR 528 (Bankr, S.D. N.V. for the foreseeable future. They provide an attractive, 1991).

This article is reprinted with the publisher’s permission from the COMMERCIAL LENDING REVIEW, a bi-monthly journal published by CCH IN COR PO RAT ED. Copying or distribution without the pub lish er’s permis- sion is prohibited. To subscribe to the COMMERCIAL LENDING REVIEW or other CCH Jour nals please call 800-449-8114 or visit www.tax.cchgroup.com. All views ex pressed in the articles and col umns are those of the author and not necessarily those of CCH IN COR PO RAT ED or any other person.

16 COMMERCIAL LENDING REVIEW SEPTEMBER–OCTOBER 2004