Negotiating Intercreditor Agreements as Bankruptcy...

106
CLICK ON EACH FILE IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If no column is present: click Bookmarks or Pages on the left side of the window. If no icons are present: Click V iew, select N avigational Panels, and chose either Bookmarks or Pages. If you need assistance or to register for the audio portion, please call Strafford customer service at 800-926-7926 ext. 10 Negotiating Intercreditor Agreements as Bankruptcy Filings Soar Strategies for First and Second Lienholders in an Uncertain Enforcement Environment presents Today's panel features: Mark N. Berman, Partner, Nixon Peabody, Boston C. Edward Dobbs, Partner, Parker Hudson Rainer & Dobbs, Atlanta Randall L. Klein, Principal, Goldberg Kohn, Chicago Tuesday, May 26, 2009 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference. A Live 90-Minute Audio Conference with Interactive Q&A

Transcript of Negotiating Intercreditor Agreements as Bankruptcy...

CLICK ON EACH FILE IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS.

If no column is present: click Bookmarks or Pages on the left side of the window.

If no icons are present: Click View, select Navigational Panels, and chose either Bookmarks or Pages.

If you need assistance or to register for the audio portion, please call Strafford customer service at 800-926-7926 ext. 10

Negotiating Intercreditor Agreements as Bankruptcy Filings Soar

Strategies for First and Second Lienholders in an Uncertain Enforcement Environment

presents

Today's panel features:

Mark N. Berman, Partner, Nixon Peabody, Boston

C. Edward Dobbs, Partner, Parker Hudson Rainer & Dobbs, Atlanta

Randall L. Klein, Principal, Goldberg Kohn, Chicago

Tuesday, May 26, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 90-Minute Audio Conference with Interactive Q&A

Enforcing Intercreditor Agreements in Bankruptcy

Mark N. BermanNixon Peabody LLP100 Summer StreetBoston, MA 02110(617) 345-6037 [email protected]

©2008 Mark N. Berman

2

ENFORCEABILITYin

Bankruptcy

3

Applicable Statute• Section 510(a) of the Bankruptcy Code:

• “A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”

– So……what is a subordination agreement?• Priority for sure• Waivers of rights in bankruptcy cases?

– So……to what extent is a subordination agreement enforceable outside of bankruptcy?

• Section 9-339 of the UCC:“This article does not preclude subordination by agreement by a

person entitled to priority.”• Courts generally look to state contract law:

» Are the provisions clear and unambiguous?» If they are ambiguous, what was the intent of the parties?

-but consider 203 N. LaSalle and Hart Ski

• Is UCC §§1-102(3) and 9-602 cmt. 2, relevant? See Robert Stein, Enforcement of the Silent Second Lien, 27 UCC L. J. 165 (1994).

4

Basic Argument

Freedom of Contract

v

Bankruptcy Public Policy

5

Why does it Matter?• In the context of a Second Lien Financing:

• Secured creditors have an interest in the debor’s property and, therefore, rights to adequate protection.

– Makes it more difficult to arrange for DIP Financing or the use of cash collateral in the early days of a case.

• Secured creditors are usually entitled to be classified separately from other secured and all unsecured creditors so that confirming a plan of reorganization may be more difficult.

• Who gets Reorganization Securities?

• In the context of Mezzanine Financing:

• Mezz is generally not secured, so no adequate protection issue.– However, there have been recent mezz deals involving a

subordinate lien on assets. • Since the mezz lender is generally unsecured, depending on the size

of the mezz debt, the mezz lender may be able to control the class of unsecured creditors voting on the plan of reorganization and,thereby, make confirmation of that plan more difficult.

• Who gets Reorganization Securities?

6

Case Law in Favor of Enforcement of Bankruptcy Provisions in Intercreditor Agreements

• Blue Ridge Investors, II, LP v. Wachovia Bank, N.A. and Aerosol Packaging, LLC (In re Aerosol Packaging, LLC), Case No. 06-67096 (Bankr. N.D. GA, 12/26/06)(On junior creditor’s motion to determine voting rights in connection with a reorganization plan, where both senior and junior creditor cast conflicting ballots, court upheld provision in subordination agreement allowing senior lender to vote the junior lender’s claim)

• Junior creditor entered into a subordination agreement with senior creditor at inception of loan. Subordination agreement modified twice pre-petition.

• Debtor is a party to the subordination agreement and entitled to rely on its enforcement.

• Provisions in subordination agreement authorized senior creditor to vote the junior creditor’s claim, and to receive any distribution allocated to the juniorcreditor.

7

Case Law in Favor of Enforcement of Bankruptcy Provisions in Intercreditor Agreements (cont.)

• Court finds that junior creditor “has provided no evidence, argument or authority that the Subordination Agreement is not enforceable under applicable nonbankruptcylaw.” Without analysis or citation, court says that “[t]he Subordination Agreement appears to be enforceable under Georgia law, which is the applicable nonbankruptcy law.”

• Junior creditor apparently had the right to purchase the senior lender’s claim. The court felt that his afforded the junior creditor a remedy.

• Same relevant facts as in the 203 N. LaSalle case. Rejects 203 N. LaSallereasoning.

Other cases that stand for the same proposition:• In re Curtis Center Limited Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996)• In re Inter Urban Broadcasting of Cincinnati, Inc., 1994 WL 646176 (E.D. La. 1994)• Braod. Capital, Inc. v. Davis Broad., Inc., (In re Davis Broadcasting, Inc.), 169 B.R.

229 (Bankr. M. D. Ga. 1994), rev’d on other grounds, 176 B.R. 290 (M.D. Ga. 1994)• Matter of Itemlab, Inc., 197 F. Supp. 194 (E.D.N.Y. 1961)

8

Case Law Against Enforcement of Bankruptcy Provisions in Intercreditor Agreements

• Beatrice Foods Co. v. Hart Ski Mfg. Co., Inc. (In re Hart Ski Mfg. Co., Inc.), 5 B.R. 734 (Bankr. D. Minn. 1980):

• Creditor (Beatrice) files a complaint seeking adequate protection or a lifting of the stay.

• Beatrice formerly owned Hart Ski. In the sale of the company, Beatrice obtained a note for $666K secured by inventory and accounts. Aetna provided financing to Hart and required Beatrice to sign a subordination agreement.

• The subordination agreement entered into by Beatrice and Aetna prior to the bankruptcy case says:

– “Creditor (Beatrice) will not, without your (Aetna’s) written consent, assert, collect or release the indebtedness or any part thereof or realize any collateral securing the indebtedness or enforce any security agreements, real estate mortgages, lien instruments, or other encumbrances securing saidindebtedness except that it may collect regularly scheduled payments when and as due as provided above.”

9

Case Law Against Enforcement of Bankruptcy Provisions in Intercreditor Agreements

Hart Ski Mfg (cont.)

• The Bankruptcy Court says:– “The intent of §510(a)(Subordination) is to allow the consensual and contractual priority of

payment to be maintained between creditors among themselves in a bankruptcy proceedings. There is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets.”

– The Bankruptcy Code guarantees each secured creditor certain rights, regardless of subordination. These rights include the right to assert and prove its claim, the right to seek court-ordered protection for its security, the right to have a stay lifted under proper circumstances, the right to participate in the voting for confirmation or rejection of any plan of reorganization, the right to object to confirmation, and the right to file a plan where applicable. The above rights and others not related to contract priority of distribution pursuant to Section 510(a) cannot be affected by the actions of the parties prior to the commencement of a bankruptcy case when such rights did not even exist. To hold that, as a result of a subordination agreement, the “subordinor” gives up all its rights to the subordinee” would be totally inequitable.”

– “No prejudice can be shown by Aetna if Beatrice is allowed to assert its claim. Any money collected by Beatrice must be held in trust by Beatrice and paid to Aetna until Aetna is paid in full.”

– See also In re Hinderliter Indus., Inc., 228 B.R. 848 (Bankr.E.D. Tex. 1999).

10

• Bank of America, NA v. North LaSalle Street Limited Partnership (In re 203 North LaSalle Street Partnership), 246 B. R. 325 (Bankr. N. D. IL 2000):

• BofA filed a complaint seeking a declaratory judgment as to the effect of subordination agreements entered into between BofA and North LaSalle Street Limited Partnership which was the general partner of the debtor.

• The general partner’s claim was an “artificial deficiency claim created by §1111(b).• Issue was whether subordinated creditor (general partner) could vote subordinated claim. • Started with BofA having made a non-recourse loan to the partnership. A year later, the

partnership obtains a second non-recourse loan, this one from the general partner. The terms of the mortgage provide that the mortgage was junior and subordinate to the Bof A mortgage. General partner also signs an Inter-Creditor Agreement with BofA.

• Several years later, in consideration of BofA waiving certain rights, general partner enters into a Consent and Subordination Agreement that includes an agreement that BofA could vote the general partner’s claim in a bankruptcy reorganization.

• Pursuant to Section 510(a), the court looked to Illinois law which provides that in the absence of ambiguity, the terms of subordination agreements are to be construed according to their plain language.

Case Law Against Enforcement of Bankruptcy Provisions in Intercreditor Agreements

11

203 North LaSalle (con’t)

• “While the language of the subordination agreements governs the outcome of the Bank’s right to repayment of any deficiency claim, the language of the Bankruptcy Code governs the determination of voting rights in this case. Section 1126(a) of the Code provides that “the holder of a claim” may vote to accept or reject a plan under Chapter 11……North LaSalle is the holder of the claim….North LaSalle should therefore be allowed to vote its claim in the confirmation process.”

• “It is generally understood that prebankruptcy agreements do not override contrary provisions of the Bankruptcy Code….Indeed, since bankruptcy is designed to produce a system of reorganization and distribution different from what would obtain under nonbankruptcy law, it would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.”

• “….§510(a), in directing enforcement of subordination agreements, does not allow for waiver of voting rights under §1126(a). “Subordination,” though not defined by the Code, has a common understanding in the law, reflected in Black’s Law Dictionary, which defines subordination as: “the Act or process by which a person’s rights or claims are ranked below those of other.”….Subordination thus affects the order of priority of payment of claims in bankruptcy, but not the transfer of voting rights.”

Case Law Against Enforcement of Bankruptcy Provisions in Intercreditor Agreements

12

203 North LaSalle (con’t)

• Cites Hart Ski.• “Although a creditor’s claim is subordinated, it may well have a substantial interest in the

manner in which its claim is treated. Subordination affects only the priority of payment, not the manner in which its claim is treated. Subordination affects only the priority of payment, not the right to payment. If assets in a given estate are sufficient, a subordinated claim certainly has the potential for receiving a distribution, and Congress may well have determined to protect that potential by allowing the subordinated claim to be voted. This result assures that the holder of a subordinated claim has a potential role in the negotiation and confirmation of a plan, a role that would be eliminated by enforcing contractual transfers of Chapter 11 voting rights.”

Case Law Against Enforcement of Bankruptcy Provisions in Intercreditor Agreements

13

Where Does that Leave Us?• Understand which provisions of the intercreditor agreement

affect priority and which do not?

• Advise client that non-priority provisions may not be enforceable.

• Senior Lenders might want to consider including those features that influenced the Aerosol court:

– Junior lender buy out of senior lender position• Usually hard for a junior lender to resist including a buy out

provision. – Debtor a party to the intercreditor agreement

• Junior lenders should consider resisting this step.

14

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T E

Issues and Information for Today’s Busy Insolvency Professional

Contributing Editor:Jo Ann J. BrightonKennedy Covington Lobdell

& Hickman LLP; Charlotte, [email protected]

Also Written by:Mark N. BermanNixon Peabody LLP; [email protected]

Unfortunately, it appears unlikelythat we will see for some time aseminal court decision that will

provide clear guidance on the likelihoodthat a bankruptcycourt will enforcethose provisions in ani n t e r c r e d i t o ragreement that areintended to conformthe actions of the firstand secondlienholders during ab a n k r u p t c yproceeding of thecommon borrower.

Bankruptcy court decisions made in theearly days of a chapter 11 case, whenmany of the intercreditor agreement pro-visions have their applicability, seldom

result in written opinions. Further, the im-pact of the uncertainty regardingenforcement of the bankruptcy provisionsin intercreditor agreements often resultsin a negotiated resolution between the

first and second lienholders entered intoprior to the bankruptcy case. Althoughthe differing views on enforceability mayimpact the ultimate terms negotiated asbetween the first and second lienholders,there is no opportunity for the bankruptcycourt, or others in the bankruptcy process,to present these issues to a bankruptcycourt for determination. As a result, webelieve that it will be helpful to presentthe limited anecdotal information that isavailable about second-lien financingswhere the borrower has now filed abankruptcy case. Part II of this article (tobe published in the March 2006 ABIJournal) will identify a sampling of thosecases and describe the ways that thebankruptcy provisions in the intercreditoragreement applicable to each case had animpact (if at all) on the ultimate outcome.

Part I of this article will discuss the“disconnect” that currently exists betweenthose negotiating the provisions con-

cerning bankruptcyin the intercreditoragreement and anyunderstanding as toexactly how thoseprovisions will playout should abankruptcy filingtake place and, ratherthan provide practicepoints or clearanswers, highlight some of the questionsor possible “mine fields” in this area thatare subject to interpretation and futureadjudication. This list is not intended tobe exhaustive, but rather thought-

provoking for those of us who deal withworking out second-lien transactions. Thelist may also provide a basis fordiscussion with the “front end” side of thefirm or with lending clients.2

The MarketSecond-lien financings have beengrowing rapidly in amount and number oftransactions since 2002.3 Borrowers havebeen attracted to second-lien financingsbecause of the lower cost as compared tomezzanine or high-yield debt. Borrowersare also looking for second-lien money tosatisfy borrowing needs that cannot orwill not be met by first lienholders. As aresult, there has been a shift in “leverage”

Second-Lien Financings: Enforcement of Intercreditor Agreements in Bankruptcy1

Part I: More Questions than Answers

News at 11

About the Author

Jo Ann Brighton is special counsel withKennedy Covington Lobdell & Hickmanin Charlotte, N.C. She is on the AdvisoryBoard of the ABI Law Review and iscertified in Business Bankruptcy by theAmerican Board of Certification. MarkBerman is a partner at Nixon PeabodyLLP in Boston.

1 This article is the product of a panel discussion on “Second LienFinancings” presented at the 2005 ABI Winter Leadership Conference inIndian Wells, Calif., on Dec. 2, 2005. The authors, together with JudgeJudith Fitzgerald, presented the topic for discussion at the meeting ofABI’s Banking and Finance Committee. Both during and after thediscussion, questions were raised regarding the enforceability of manyof the bankruptcy provisions of intercreditor agreements that areroutinely entered into by and between first and second lienholders. Wethought it would be helpful to the bankruptcy community at large ifthese questions could be exposed to a wider audience. For moreinformation concerning second-lien financings and questionsconcerning the enforceability of provisions applicable to bankruptcycases and commonly included in intercreditor agreements associatedwith second-lien financings, see Brighton, “Silent Second-LienFinancings: Popular Lending Structure May Give Rise to EnforcementProblems—Part 1: What Is Silent Second-Lien Financing?” ABI Journal,February 2005 at 22; and Brighton, “Silent Second-Lien Financings—Part II: Are They Enforceable?” ABI Journal, March 2005 at 22. Inaddition, see Berman, “Bankruptcy Public Policy and Implications forSecond-Lien Financings” published in the ABI WLC EducationalMaterials, available at www.abiworld.org/abistore.

2 It is not our intent to take all the credit for many of these questionsraised; much food for thought was generated by discussions with JudgeFitzgerald as well as the many lawyers in attendance at ABI’s 2005Winter Leadership Conference. Further, Jo Ann’s colleague J. MichaelBooe at Kennedy Covington provided his thoughts and opinions andwas an instrumental sounding board in further developing thesequestions.

3 See “Second Lien Loans Blossom,” Standard & Poors LeveragedCommentary & Data.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

Jo Ann J. Brighton

Mark N. Berman

such that second lienholders have morenegotiating power than when the second-lien market initially began to develop asa place for a short-term loan intended tobridge a time period after confirmation ofa reorganization plan or to provideseasonal funds to a business. As a resultof their growing market power, second-lien lenders have been able to improvetheir lot by moving the market terms ofmany intercreditor provisions. Forexample, standstill periods that started outin the early days of second-lien financingsas unlimited in duration have shifted to acurrently acceptable market standard ofbetween 90-180 days. Further, second-lien lenders are less likely to agree toblanket waivers of bankruptcy rights thanwere originally expected by firstlienholders. Another major change is thatwith the increased volume and popularityof second liens, full collateral coveragefor both the first- and second-lien debt nolonger appears to be an absoluteprecondition of such financing.4

Even though the growing list ofbankruptcy-related provisions in inter-creditor agreements reflects the parties’recognition that bankruptcy is a for-seeable event, many of the partiesnegotiating first- and second-liendocuments may not understand that thecontractual bankruptcy provisions in theintercreditor agreement may notnecessarily be enforced by the bankruptcycourt. As a result, while these provisionsare intended to produce predictability ofresults in a bankruptcy proceeding, thereality is anything but a certain path. It isour experience that the commonlynegotiated provisions are driven by whatis acceptable and saleable in the market,rather than by any sound understandingof how the provisions will play out in abankruptcy case.

Bankruptcy professionals understandthat the practical realities of the bankruptcyforum inevitably change possible futureanticipated actions due to time constraintsand, in many cases, rapidly dissipatingasset value. The other “overlay” that mustbe considered, but which may not be fullyunderstood by those negotiating thesedocuments, is that the tension between thepublic policy behind our country’sbankruptcy laws and the plain meaning ofthe statutory priority scheme of theBankruptcy Code will often come intoconflict with the contract entered into bythe two creditor groups (i.e., the first and

second lienholders who seek in theintercreditor agreement to impact and alterthat statutory scheme). Remember: Whenthe loan transactions are entered into, thereare only three parties (or groups of parties):the first lienholder, the second lienholderand the borrower. After a bankruptcy filing,there are many more: first lienholder,second lienholder, debtor/borrower, bank-ruptcy judge, creditors’ committee, U.S.Trustee, unsecured creditors, bondholders,equity, etc.

Potholes and Pitfalls?What follows is a list of the issues

that might be presented to bankruptcycourts about the enforceability ofprovisions commonly found in inter-creditor agreements used in second-lienfinancing transactions. We caution thatthe list is not exhaustive. However, it isintended to begin the discussion and toadd to the open issues identified in ourprior writings on this subject that havebeen referenced in Footnote 1, as well asto provoke thought concerning these, andthe no doubt countless other, issuessecond-lien financings present.

1. Raising Objections• Even if the second lienholders agree

in the intercreditor agreement to waivetheir right to object to a variety of mattersthat might arise in a bankruptcy case, e.g.,a sale of substantially all assets free andclear of the second lien holders’ lien orthe terms of a debtor-in-possession (DIP)credit facility proposed by the debtor andthe first lienholders, what stops thesecond lienholders from objectinganyway?

• Presumably, the first lienholderwould move to strike the objection on thebasis that the second lienholder agreednot to raise it. However, once theobjection is raised, even if it cannot bepursued by the second lienholder, is itlikely that the court will not consider whatwas said in the objection?

• Can’t many of the same objectionsbe raised by the unsecured creditors’committee or the U.S. Trustee?

• Might a bankruptcy judge choose tohear the second lienholders’ objection in thecontext of the bankruptcy and let the issue ofthe enforceability of the waiver in theintercreditor agreement be heard andultimately resolved in a nonbankruptcy courtsomewhere and at some time in the future?Alternatively, might a bankruptcy judgestrike the objection based on the presumedenforceability of the intercreditor agreementrequiring the second lienholder to go to a

nonbankruptcy court for a determination asto whether the waiver is enforceable? (Ofcourse, by the time the issue is heard in statecourt, the bankruptcy objection would likelybe moot).

• Does the bankruptcy court have therequisite jurisdiction to rule on theenforceability of provisions in theintercreditor agreement because it is“related to” the bankruptcy case or“affects the administration” of thebankruptcy estate, or is it simply a disputebetween two nondebtors that is outside ofa bankruptcy court’s jurisdiction?

• Will specific performance of thebankruptcy terms of an intercreditoragreement be available as a remedy to thefirst lienholders?

• What is the measure of damages forbreach of the intercreditor agreement?

2. DIP Credit Facilities• Should the amount of priming DIP

loans to be provided by the firstlienholders be counted against the seniordebt cap sometimes included in theintercreditor agreement as a restrictionagainst more debt coming ahead of thesecond lienholders? If it is, won’t thiscause first lienholders to consider liningup a DIP for the borrower using asurrogate DIP lender?

• Assuming the priming DIP is in thebest interests of the debtor and unsecuredcreditors, and assuming the interests ofthe second lienholders can be adequatelyprotected, should a bankruptcy courtconsider the use of a senior debt cap asviolative of bankruptcy public policy?

• Is it likewise against bankruptcypublic policy to prohibit second lien-holders, by the terms of the intercreditoragreement, from extending DIP financingon better terms than the first lienholderscan, or are willing to, extend?

• Should first lienholders be permittedto include an affirmation of the validityand enforceability of the intercreditoragreement in the DIP credit facility order(which, of course, is accompanied by avoluminous motion and which itself maybe an enormous document to read)?Assuming such a provision is to bepermitted, should local rules require theprovision to be highlighted, or might theymake many other provocative provisions?

• If such a provision is permitted, andif the bankruptcy court signs the DIPfinancing order with such an affirmation,is the court later prohibited fromrevisiting some of the provisions in theintercreditor agreement that may violatebankruptcy public policy (e.g., a waiver

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

4 See Batty and Brighton, “Silent Second Liens: Will the BankruptcyCourts Keep the Peace?,” N.C. Banking Institute Journal, April 2005.

by the second lienholders of their right tovote on a reorganization plan)? In otherwords, does the first lienholders’ relianceon the DIP order in extending the DIPfacility trump bankruptcy public policy?

3. Plans• If the intercreditor agreement

contains no waiver by the secondlienholders of the right to file areorganization plan (and even if there is),what prevents a second lienholder fromfiling a plan (and if it does not, then acreditors’ committee) that crams downthe first lienholders such that the first-liendebt will be paid over a period of years ata Till interest rate?

• If so, and if the plan does notprovide otherwise, what are the terms ofthe crammed down first-lien debt?

4. Classification• If the holders of the first- and

second-lien debt were the same partiesat inception, or become the same partiesthrough the trading of bank syndicateclaims over time, should the twoobligations be collapsed into one class forthe purposes of plan classification, post-petition interest, etc.? After all, even ifthere are two sets of loan documents, isn’tthat really just an agreement between twonondebtor parties that should not bind thecourt from treating similar claimssimilarly?

• Is the decision on classificationaffected by whether the collateral agentfor the first- and second-lien holders isthe same party?

5. Officers of the Court and the Dutyof Candor

• If the second lienholder agrees notto object to the validity, extent, perfectionand priority of the first lien, but is awareof a perfection problem with the first lien,does the attorney for the secondlienholder have a duty to the bankruptcycourt to apprise it of the issue?

• Assuming the same set of facts,what if the DIP facility is a roll-up of thefirst lien—could the failure to advise thecourt of a defect in the first lien beconsidered a fraud on the court?

6. Fraudulent Transfers• Are there fraudulent-conveyance

issues lurking if, at the outset of thelending transaction, there was no value inthe collateral to reach the second-liendebt, rendering it unsecured?

7. Recharacterization• Is there any risk that second-lien debt

can be recharacterized as equity rather thanunsecured debt if collateral value sufficientto cover the amount of the second lien and

sufficient cash flow are not there at theoutset of the loan? After all, repayment ofthe second-lien debt would be entirelyconditioned upon the future performanceof the borrower and, in a sense, the second-lien holders are sharing in the risk of thefuture performance of the borrower, justlike equity.

8. Exposure to Claims of UnsecuredCreditors

• In the context of the refinancing of atroubled borrower with a second-lienfinancing, might the second lienholders (notto mention the officers and directors of theborrower) be at risk for claims being madeagainst them relating to the deepeninginsolvency of the borrower? Is there alender-liability concern based on anallegation that the second lienholders shouldnot have lent money in the first place?

• Could there be claims raised againstthe first and/or second lienholders thatthey aided and abetted in the breach ofthe principals’ fiduciary duties byallowing them to take on more debt thanthe borrower could possibly repay andthereby causing harm to the unsecuredcreditors (or equity) for which thosecreditors are entitled to be compensated?What if the first lienholders extend thesecond-lien debt to repay a portion of thefirst-lien obligation?

9. The Role of the Other PartiesInvolved in Bankruptcy Cases

• Are these, and other issuespreviously highlighted in prior writings,issues that exist just between the first andsecond lienholders? Does the debtor, U.S.Trustee, creditors’ committee, equity orthe bankruptcy court have a right to beheard on these issues, and do they carehow these issues get resolved?

We will answer the last question withour opinion, but leave the other issuesopen for thought (and resolution by abankruptcy judge in the future). It appearsthat the issues surrounding the en-forcement of the provisions in theintercreditor agreement impact more thansimply the first and second lienholders. Ifthe intercreditor agreement bankruptcyprovisions make it impossible for thedebtor to secure DIP financing, the casecould convert before the debtor ever hasa chance to reorganize or sell off its assetsin an orderly way intended to realizegoing-concern value. The loser may in thefirst instance be the second-lien lender,but the unsecured creditors also lose theability to negotiate over what they mightreceive by way of a “give-up” or for theircooperation in a reorganization plan.

While the intercreditor agreement is acontract between nondebtor parties, someof the bankruptcy provisions have theeffect of “contracting away” certainstatutorily afforded rights under the Code,and therefore impact the delicatelybalanced mechanism for the conduct ofbankruptcy cases and the negotiations thattake place in those cases. Further, it iseasy to see how the outcome of many ofthese disputes would ultimately affect theadministration of the bankruptcy estateand thereby be of concern to the U.S.Trustee or the court.

Ultimately, the question of whetherbankruptcy provisions in intercreditoragreements are enforceable may comedown to a bankruptcy court’s deter-mination of what exactly is a“subordination agreement” and, assumingan intercreditor agreement is asubordination agreement, which of itsprovisions are entitled to be enforced by§510(a) of the Code—purely paymentsubordination, or much more? In the end,as this growing area further evolves, morequestions than answers continue todevelop.

Stay tuned for Part II next month andan anecdotal discussion of recent caseswhere second-lien financings have hit thebankruptcy courts, and how these issueshave played out to the benefit ordisadvantage of the parties. ■

Reprinted with permission from the ABIJournal, Vol. XXV, No. 1, February 2006.

The American Bankruptcy Institute is amulti-disciplinary, nonpartisan orga-nization devoted to bankruptcy issues. ABIhas more than 11,000 members,representing all facets of the insolvencyfield. For more information, visit ABI Worldat www.abiworld.org.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T E

Issues and Information for Today’s Busy Insolvency Professional

Written by:Mark BermanNixon Peabody LLP; [email protected]

Contributing Editor:Jo Ann J. BrightonKennedy Covington Lobdell & HickmanCharlotte, [email protected]

Part I of this article was published inthe February issue. Our objectivefor that article was to provide

supplemental information to previousarticles on second-lien financing byrelating some of the issues and questionsraised at a panel presentation on this topic

in which the authorsand Hon. JudithF i t z g e r a l d 1

participated at ABI’s2005 WinterLeadership Confer-ence. As previouslystated in thosearticles, there is littlepublished case lawaddressing second-

lien financing issues, or the enforceabilityof the many commonly includedbankruptcy provisions in the intercreditoragreements that are a critical piece of thesecond-lien financing documentation. Theauthors have speculated that the dearth ofcase law is due in part to the timeconstraints with which the participantsin many highly leveraged bankruptciestoil, and the resultant necessity to settlemany of the issues amicably or otherwise,in the end, no party benefits.

Part II of this article begins with thefirst in a series of anecdotal reports2 in

which we will share with you experiencesin recent chapter 11 cases that involvesecond-lien financings. We title thesereports “The Good, the Bad and theUgly,” but leave it to the reader to decidein which category each case falls. In eachof the cases, the parties and/or thebankruptcy court have had to wrestle with

the impact of the first/second-lienstructure and its impact on thereorganization or liquidation process andthe likely interpretation or enforceabilityof provisions in the intercreditoragreements. Our hope is that by sharingthis information, the parties andbankruptcy attorneys involved in futurecases might be better prepared to dealwith similar issues, or at least beforewarned as to what might happen if theissues are not successfully resolved.

We begin the series with theAmerican Remanufactures case3 out ofthe U.S. Bankruptcy Court in Delawareand over which Hon. Peter Walshpresided. The case did not result in anywritten opinions that we are aware of, butis a fascinating example of what happenswhen the parties cannot reach asettlement. It appears to the authors thatno one benefited by the parties’ inability

to resolve the intercreditor issues,although we leave readers to draw theirown conclusions.

The Chapter 11 CaseAmerican Remanufactures Inc., et al

(debtor) filed petitions for chapter 11relief on Nov. 7, 2005. The debtor was aroll-up and employed 1,400 people. Thedebtor’s first-lien credit facility wasoriginally negotiated in March 2005, lessthan nine months prior to the chapter 11case, and it included a revolver and termloan aggregating $50 million that wassecured by substantially all of the debtor’sassets. While it had not been involvedwhen the first-lien credit facility hadoriginally been negotiated and docu-mented, at the time the petition for

bankruptcy reliefwas filed, BlackD i a m o n dCommercial FinanceLLC was the agentfor the firstlienholders andcontrolled that seniorlien position. Thesecond-lien creditfacility involved a

term loan of $40 million and was alsosecured by a junior lien on substantiallyall of the debtor’s assets. At the start ofthe chapter 11 case, the second-lien posi-tion was controlled by DDJ Capital Man-agement LLC, which also served as agent,and Airlie Opportunity Master Fund Ltd.The second lienholders also held a $4million piece of the first-lien credit facility.As part of the first-day motions, the debtorasked the bankruptcy court to approve a

Second-Lien FinancingsPart II: Anecdotes and Speculation—the Good, the Bad and the Ugly

News at 11

About the Author

Jo Ann Brighton is special counsel withKennedy Covington Lobdell & Hickmanin Charlotte, N.C. She is on the AdvisoryBoard of the ABI Law Review and iscertified in Business Bankruptcy by theAmerican Board of Certification. MarkBerman is a partner at Nixon PeabodyLLP in Boston.

1 U.S. Bankruptcy Court for the Western District of Pennsylvania.2 The authors reviewed some, but not all, of the pleadings and spoke to

some, but not all, of the parties involved in the case discussed in thisarticle. Our sincere apologies if any information we report in this articleis incorrect, or if the motivations we speculate about are inaccurate. 3 Delaware-Case no. 05-200022 (filed 11/7/05) (Judge Walsh).

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

Jo Ann J. Brighton

Mark N. Berman

$30 million DIP financing credit facilityto be provided by the first lienholders. Asa normal part of the first-/second-liencredit faculties’ documentation, an inter-creditor agreement existed and includedthe following provision:

Section 2.2. Lien Priority.Notwithstanding the date, manneror order of grant, attachment orperfection of any liens securingthe second-lien obligations grant-ed on the collateral or of any lienssecuring the first-lien obligationsgranted on the collateral andnotwithstanding any provision ofthe Code or any applicable law orthe second-lien credit documents,the second-lien agent, on behalfof itself and the other second-lienclaimholders, hereby agrees that(a) any lien on the collateralsecuring any first-lien obligationsnow or hereafter held by or onbehalf of the first-lien agent orany other first-lien claimholder orany agent or trustee therefore,regardless of how acquired,whether by grant, possession, stat-ute, operation of law, subrogationor otherwise, shall be senior in allrespects and prior to any lien onthe collateral securing any of thesecond-lien obligations; and (b)any lien on the collateral now orhereafter held by or on behalf ofthe second-lien agent, any othersecond-lien claimholder or anyother agent or trustee thereforeregardless of how acquired,whether by grant, possession,statute, operation of law,subrogation or otherwise, shall bejunior and subordinate in allrespects to all liens on thecollateral securing any first-lienobligations, provided that if thefirst-lien agent voluntarily agreesto subordinate any liens on anycollateral securing the first-lienobligations to any liens securingobligations owing from thecompany or the other creditparties to any third party (otherthan liens expressly permittedunder §6.7 of the first-lien creditagreement as in effect on the dateof this agreement), then theprovisions relating to the priorityof liens and subordination ofpayments set forth herein shallnot be effective with respect to thecollateral which is the subject of

the liens securing the first-lienobligations that were voluntarilymade subordinate to the lienssecuring the obligations owing tothird parties; provided further thatthe forgoing proviso shall notapply to any subordination ofliens on any collateral securingthe first-lien obligations to lienson such collateral securing otherfirst-lien obligations. Except asprovided in the provisos to theimmediately preceding sentence,all liens on the collateral securingany first-lien obligations shall beand remain senior in all respectsand prior to all liens on thecollateral securing any second-lien obligations for all purposes,whether or not such liens securingany first-lien obligations aresubordinated to any lien securingany other obligation of ARI, thecompany, any other credit partyor any other person (emphasisadded).

The Intercreditor Agreement alsoincluded a cap on the total amount offirst-lien obligations to which the secondlien would be junior.

Prior to the chapter 11 filing, and notlong after the first- and second-lien creditfacilities were put in place, newmanagement for the debtor arrived andannounced that earnings for the prior yearneeded to be restated; the debtor was notperforming to plan and was losing money.A short-term forbearance agreement wassuccessfully negotiated that increased therevolver, but covenant problems arose,and the debtor was in default of theforbearance agreement just six weeksthereafter. The first-lien notes weretrading at a discount to par.

When the chapter 11 case began, thedebtor could not live on its own cash flowand therefore, like so many other chapter11 debtors, needed a DIP credit facility.The debtor obtained offers for DIP creditfacilities from both the first and secondlienholders. The first lienholders wouldnot consent to being primed by the DIPcredit facility proposed by the second-lienlenders, and the second-lien lenderswould not consent to being primed by theDIP credit facility proposed by the first-lien lenders. The debtor, believing thatthe first lienholders were undersecuredand, therefore, the second lienholderswere entirely unsecured, elected toproceed with the first lienholders’ DIPproposal. Influencing that decision was

the debtor’s belief that it could notprovide adequate protection to the firstlienholders.

The DIP motion was heard by thecourt on Nov. 9, 2005 (i.e., the third dayof the case). The DIP motion included,inter alia, tying the DIP credit facility toa quick sale of the debtor’s assets withBlack Diamond serving as the stalkinghorse. In connection with the DIP motion,the debtor presented the court with aliquidation analysis showing that therewas no value in the collateral for thesecond lienholders and concluding thatthey were unsecured. The proposed DIPorder included the following provision:

The imposition of the DIP liens,and any agreement or consent bythe pre-petition senior agentand/or pre-petition senior lendersprovided herein, does not violateor breach any provisions of theintercreditor agreement, nor doesit affect, alter or otherwise modifythe priorities between the pre-petition senior liens and pre-petition senior indebtedness onthe one hand, and pre-petitionjunior liens and pre-petition juniorindebtedness on the other hand,including, without limitation, as aresult of §2.2 of the intercreditoragreement.

In response to the debtor’s DIP motion,the second lienholders filed an objectionidentifying the following issues:

• Less expensive and less restrictivefinancing was available. Prior to thechapter 11 case being filed, thesecond lien holders had offered toprovide a DIP credit facility on bettercredit terms (25 basis points less) thanthe DIP credit facility proposed by thedebtor with the first lien holders andwithout the sale of assets requirement.Going with the second lien holders’DIP credit facility would, therefore,permit the case to go forward towarda normal reorganization rather than aquick sale.• The proposed DIP facility required aquick liquidation of assets with theDIP lender serving as the stalking-horse. Pre-petition, the second lienlenders had submitted what theybelieved to be a better offer for theassets that the one the debtor proposedto make the stalking-horse, but thedebtor apparently rejected that offerbecause, as reported by the second lienlenders, had the debtor accepted thatoffer, the debtor would not have been

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

able to secure DIP financing.• The DIP facility was a sub rosa planbecause it required the immediateliquidation of the debtor’ assets (i.e.,within 75 days of the date the chapter11 case had been filed) and altered therights of the second lienholders byputting them in a position where anysuccessful objection they mightpursue to the proposed sale of allassets jeopardized the DIP creditfacility.• The DIP facility violated theintercreditor agreement byinvalidating its §2.2. In the view ofthe second lienholders, §2.2 on theIntercreditor Agreement, coupledwith the priming liens to be grantedto the DIP lenders as part of the DIPcredit facility without the consent ofthe second lienholders, would renderthe first lienholders lien pari passuwith that of the second lienholders.• The DIP credit facility requiredpriming liens without providing thesecond lienholders with adequateprotection as required by §364(d) ofthe Code. In this context, the secondlienholders took the position that thegoing-concern value of the debtor’assets was higher than the liquidationvalue, and while the liquidation valuemight not produce anything to reachthe second lien, the debtors had notmet their burden of proof that thesecond lienholders were out of themoney if the debtor’s business werevalued as a going concern.The hearings on the DIP credit

facility lasted for four days. Noindependent valuation expert testimonywas presented by either party, althoughevidence was presented that the value ofthe collateral, even on a going-concernbasis, was insufficient to pay the firstlienholders in full. In what it probablybelieved would set the stage for anegotiated resolution between the firstand second lienholders, the court, in apreliminary ruling, decided that theproposed DIP credit facility triggered theproviso in §2.2 of the intercreditoragreement underlined above. However, itwas not clear what result followed fromtriggering §2.2. The language of §2.2states that if the underlined proviso istriggered, the lien priority provisions ofthe intercreditor agreement would not beeffective as between the first and secondlienholders. At first, the court ruled thatshould the DIP facility be approved,while the DIP loan would be have the

benefit of a senior lien on all assets, thetriggering of the underlined provisomeant that the first and second lienswould share pari passu behind the DIPcredit facility. However, at the request ofthe first lienholder, and although thetranscript is not clear on this point, thecourt later seemed to back away fromdetermining that pari passu status wouldresult and left the door open to theargument that state law would determinethe relative priority as between the firstand second lienholders (i.e. the first to filewould prevail). At this point, unwillingto risk losing the priority of its first lien,Black Diamond withdrew its offer of aDIP credit facility. This ruling was clearlya victory for the legal position advancedby the second lienholders who sought toprevent the first lienholders fromcontrolling the chapter 11 case andforcing a sale process via the DIP creditfacility. However, the victory wasfleeting.

While the court and the debtor mayhave believed that a deal was there to bestruck between the first and secondlienholders, none was forthcoming. Thefirst lienholder was adamant that it hadsenior rights in the collateral to those ofthe second-lien lenders, that there was novalue for that junior position and that itwould rather liquidate the collateral thanshare that value. From the vantage pointof the second lienholders, there wassimply no willingness of the firstlienholders to negotiate. An offer by thesecond lienholders to buy out the firstlienholders was rejected. With no DIPcredit facility available, no way to breakthe impasse between the first and secondlienholders, and running out of cash, thedebtor moved to convert to chapter 7.When that conversion motion wasgranted, the operations were shut downand 1,400 employees were out of work.The liquidation was completed about 60days later by a chapter 7 trustee who, inmid-January 2006, closed on a sale of allof the assets to one of the participants inthe first-lien credit facility. No value isexpected to be realized from the sale ofthe assets for the second lien holders orfor unsecured creditors.

ObservationsAn observer has opined that the first

and second lienholders took out theirguns and shot each other. From anyperspective, it is hard to understand whowon or who benefited by the resultachieved in this case. Certainly not the

debtor, which was closed and its assetssold by a chapter 7 trustee. The firstlienholders don’t appear to have achievedmuch as they will now receive theproceeds of a chapter 7 liquidation oftheir collateral realized after the businesshad been closed for 60 days, rather thanbenefiting from the higher reorganizationvalue usually achieved in a successfulreorganization or the going-concern valuethat can usually be realized by a sale ofthe ongoing business during the chapter11 case. However, the first lienholders didachieve a rather quick liquidation of theassets, and didn’t suffer the debtor’songoing losses from operations or thecontinued legal costs associated withfighting with the second lienholders overevery issue going forward in a chapter 11case. In the words of one of theparticipants, at least the case was“mercifully short.” The secondlienholders seem not to haveaccomplished any monetary benefit forthemselves, although they did win thelegal argument over the interpretation of§2.2 of the intercreditor agreement. Inaddition, if they were out of the moneywhen the case began based on a realisticvaluation of their collateral, then theydidn’t lose anything by failing to reach anagreement. The second lienholders justfailed to gain anything. Of course,whatever they paid to acquire the second-lien claims was lost, but that had alreadybeen lost when the chapter 11 case began.The unsecured creditors, owed over $22million, are certainly not winners as theyhave no future business prospects withthe debtor and will not receive anythingon their unsecured claims unless theavoidance powers of the chapter 7 trusteeproduce recoveries. Accordingly, it’s hardto conclude that the unsecured creditorsare in a better place. Finally, theemployees are out of their jobs, and thosethat don’t catch on with the new ownersare perhaps the biggest losers.

The question thus becomes: Didanyone win? Presumably, for the firstlienholders, the answer depends on howthey compare the value realized by thechapter 7 trustee’s sale of the debtor’sassets against what might have beenrealized in a chapter 11 going concernauction less whatever they might havehad to pay to the second lienholders toreach a settlement of the intercreditorissues. The second lienholders appear tohave won the pyrrhic victory of thecourt’s agreement with their interpretationof the language in §2.2 of the intercreditor

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

agreement. However, it appears that boththe first and second lienholders believethey achieved something—in the form ofthe message the case sends to those whowill be involved with them in second-lienfinancing cases in the future. The firstlienholders’ message: “First lienholdersare senior to second liens. We wouldrather risk realizing the depressed valuesof a chapter 7 liquidation than give tojunior secured parties some of the valueto which we are entitled.” The secondlienholders’ message: “We’re willing tolose it all rather than allow the first-lienlender to dictate all aspects of the chapter11 process including control over thereorganization and sale processes.” Inother words, “if you don’t play ball withus by either giving us a piece of the actionor an opportunity to realize value throughreorganization, then you’ll suffer.”Whether these messages have any realvalue to the parties involved will only beseen in the wake of that next case. Timewill tell.

Could this case have turned outotherwise? Certainly. The secured partiescould have reached some type ofagreement over the DIP credit facility thatwould have resolved how asset valuecould have been shared in a chapter 11sale or by way of a traditionalreorganization. For whatever reason, suchan agreement was not to be in this case.Perhaps there simply was not enoughtime to get to the promised land of anegotiated resolution. Alternatively, thecourt could have conducted a valuationhearing as part of the first-day hearingprocess. Had this resulted in a finding thatthe second lien was entirely out of themoney, it is possible, although notassured, that the court could haveconcluded that the intercreditor agreementhad no continued viability. It appearsproblematic whether there was adequatetime to conduct such a hearing in theearly days of the case, whether the courtwould even have been willing to do so,and what the testimony on value wouldhave been. There is also the possibilitythat the second lienholders still had theright to insist upon the §2.2 result even inthe face of a second lien unable to reachvalue in the collateral.

However, an important observation isin the language of the intercreditoragreement. As far as we are aware,although the concept at play in §2.2 (i.e.,limits to the ability of the first lienholdersto negotiate priming liens in DIP creditfacilities) remains an expected piece of

the intercreditor agreement negotiations,the actual language used in §2.2employed in the AmericanRemanufacturers’ intercreditor agreementto accomplish that goal is not the normfor intercreditor agreements currentlybeing negotiated in first- and second-liencredit facilities. While it is hazardous todefine what “market” is at any given time,if a “market” in intercreditor agreementterms in fact ever exists, the current normappears to involve the interplay of severalprovisions. To begin with, firstlienholders receive a blanket consentfrom second lienholders to imposepriming liens in a DIP credit facility. Toprotect the second lienholders from animprovident DIP credit facility forcedupon them by the first lienholders, thisblanket consent to DIP credit facilitiesapproved by the first lienholders is oftencoupled with a variety of limitationsincluding one or more of (1) a cap on theamount of debt that can come ahead ofthe second lienholders in the prioritystructure, (2) a cap on the amount of theDIP credit facility or (3) a limitation onthe features of a permitted DIP creditfacility addressing provisions that dictateplan or sale terms. In addition, currentforms of intercreditor agreements oftenallow the second lienholders to purchasethe first lienholders’ claims at par,although it is not clear that this wouldhave resolved the problem with theAmerican Remanufacturers’ case becausethe second lienholders may have not beenwilling to pay par for the first-lienposition. The first-lien position isunderstood to have been trading at adiscount to par, meaning that the secondlienholders would be paying more thanmarket price to protect their second-lienposition. However, in other distressedsituations, the right to purchase a seniorposition at par might give secondlienholders, who believe their second-lienposition has value, a means by which toremove the impediment of a recalcitrantfirst lienholder.

ConclusionSo we will allow the readers to

decide: good, bad or ugly? Regardless ofthe label, the American Remanufacturerscase is significant for what did nothappen—specifically, the inability of theparties to achieve a consensual settlementamong the first- and second-lien lendersconcerning disputes arising out of theterms of the intercreditor agreement. Italso emphasizes two points made by the

authors in Part I of this article. First, whilemany of the commonly included (andheavily negotiated) provisions inintercreditor agreements in second-lientransactions may not be enforceable,enforceability may not be worthwhile tolitigate because time is short, resourcesare limited, the outcome is far fromcertain and the parties may not like theoutcome even if you convince the courtthat your interpretation is correct. Second,when crafting the language of anintercreditor agreement or acquiring asecured position subject to such adocument, it is essential that attorneysfamiliar with bankruptcy law and thereality of chapter 11 practice be consultedon the terms of the intercreditoragreement so that they can consider andadvise clients on the impact of clausesthat only have meaning in the context ofa chapter 11 case.

Stay tuned for next month, when wediscuss another recent bankruptcy casethat involved second liens andintercreditor issues, but that yielded quitedifferent results—the Atkins Nutritionalschapter 11 case. ■

Reprinted with permission from the ABIJournal, Vol. XXV, No. 1, February 2006.

The American Bankruptcy Institute is amulti-disciplinary, nonpartisan orga-nization devoted to bankruptcy issues. ABIhas more than 11,000 members,representing all facets of the insolvencyfield. For more information, visit ABI Worldat www.abiworld.org.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T E

Issues and Information for Today’s Busy Insolvency Professional

Contributing Editor:Jo Ann J. BrightonKennedy Covington Lobdell & HickmanCharlotte, [email protected]

Also Written by:Mark N. BermanNixon Peabody LLP; [email protected]

This is the third installment in aseries of articles that focus on theactual experiences realized when

second-lien financings hit the bankruptcycourts. In the second installment printedin the March Journal, we explored theAmerican Remanufacturers case.1 This

third installmentexplores the AtkinsNutritionals Inc., etal, chapter 11 cases.As a reminder, thisreport is purelyanecdotal.2 However,it is readily apparentthat the comparisonswith the firstinstallment could not

be more striking. Atkins resulted in aconfirmed chapter 11 reorganization plan,a continuing business operation, and bothfirst- and second-lien lenders participatingin the reorganized company. By contrast,American Remanufacturers cratered at thevery start—unable to resolve differencesbetween the first- and second-lien lenderson the terms of the DIP credit facility. Thecase was converted to a chapter 7liquidation and the assets sold by thechapter 7 trustee. In our view, nobodygained a thing by the battle over rightsbetween the first- and second-lien holders

contained in the intercreditor agreement.

Background and WorkoutThe Atkins story has its roots in 1972,when Dr. Atkins published his first bookabout low carbohydrate (low-carb)dieting. A second book on the same topicwas published in the ’90s and became a

best-seller. Paralleling the publishing ofsecond book, Dr. Atkins established acorporation that introduced a low-carbfood product in 1997. More productsfollowed, and as the low-carb diet becamea significant force in American society,the company grew to meet a growingdemand. In 2003, the company, AtkinsNutritionals, was acquired by ParthenonCapital Inc. and its affiliates along withGoldman Sachs Capital Partners and itsaffiliates. While the acquisition includeda significant amount of equity put into thecompany by its new owners, it alsoincluded a significant credit facility inwhich UBS served as the agent for asyndicate of secured lenders. The creditfacility involved a single creditagreement,3 and UBS served as the single

collateral and administrative agent fortwo levels of secured debt. The first levelwas granted a first lien on substantiallyall assets of Atkins Nutritionals and itsaffiliates, while the second level wasgranted a second lien on those sameassets. Each level was widely syndicated.

However, the low-carb diet revealeditself as a fad, and the growth of demandfor Atkins Nutritionals cooled in 2004 asthe company’s performance was furtherhit by competitive products fromestablished food manufacturers. Later in2004, Atkins Nutritionals defaulted on itspre-petition credit agreement. A workoutensued.

During the workout, several thingsbecame apparent. First, the first-lienlenders could “control” the process by

outvoting the second-lien lenders on thosematters governed bythe pre-petition creditagreement. As aresult, declaring adefault or takingenforcement actionsthat might be thesubject of ani n t e r c r e d i t o r

agreement and a resultant standstill periodfor the second-lien lenders were all in thecontrol of the first-lien lenders, whodominated due to the size of the first-liencredit when compared to the second-liencredit.4

Second-Lien FinancingsPart III: Anecdotes—the Good, the Bad and the Ugly: Atkins—the Good

News at 11

About the Author

Jo Ann Brighton is special counsel withKennedy Covington Lobdell & Hickmanin Charlotte, N.C. She is on the AdvisoryBoard of the ABI Law Review and isBoard Certified in Business BankruptcyLaw by the American Board ofCertification. Mark Berman is a partnerat Nixon Peabody LLP in Boston.

1 (Delaware-Case no. 05-200022) (filed 11/7/05) (Judge Walsh).2 The authors reviewed some, but not all, of the pleadings and spoke to

some, but not all, of the parties involved in the case discussed in thisarticle. Our sincere apologies if any information we report in this articleis incorrect or if the motivations we speculate about are inaccurate.

3 It has become more common for second-lien lenders to insist uponseparate credit agreements with separate security agreements and UCCfinancing statements to document their secured loans with an inter-creditor agreement being negotiated between the two. See Kerr andRovito, “Second Lien Evolution Creates Higher Recovery Prospects—AtFirst Lien Lenders’ Expense,” Ratings Direct, Aug. 5, 2005.

4 The authors believe that most current second-lien financings documentedtoday involve separate credit agreements for the first- and second-lienlenders. This approach enhances the likelihood that a bankruptcy court willview the two sets of lenders as holding separate loans rather than asparticipants in a single loan. This issue has ramifications for classificationin chapter 11 plans as well as the right to accrue post-petition interest andadequate protection. As can be seen from the Atkins Nutritionalsexperience, it also has ramifications for the ability of the second-lienlenders to impact the workout and chapter 11 process. See In reIonosphere Clubs Inc., et al, 134 B.R. 528 (S.D.N.Y. 1991).

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

Jo Ann J. Brighton

Mark N. Berman

Second, there was a significant amount ofcross-ownership of the first- and second-lien positions, so much so that it becamedifficult to find lenders who participatedin only one of the positions and who wouldbe willing to serve on a steering committee(a group often formed when a syndicatedsecured loan goes into default in order tomake the process of negotiation anddecision-making more streamlined). As aresult, most lenders looked at the creditfacility from a total-return standpoint ratherthan exclusively from the standpoint of thefirst- or second-lien position. This probablyreduced the amount of friction between thetwo positions.

Third, many of the lenders who hadacquired their positions via trading had aperception that their rights were different thanthe documentation revealed was true. Severalfirst-lien lenders believed they enjoyed thebenefits of debt subordination rather thanonly lien subordination. The “waterfall”provisions of the credit agreement addressedonly distributions from collateral and notpayments that the first- or second-lien lendersmight obtain outside of collateral liquidation.

Fourth, the first-lien lenders generallyfavored a quick sale of the company wherethey could realize what they believed to bethe current value of the company. The first-lien lenders believed that the liquidation ofthe company would result in less thanpayment in full of their first-lien position.

Fifth, the second-lien lenders generallywanted a chance to realize the value thatmight be created over and above the first-lienposition if the company could be reorganizedand proceed profitably into the future. Whilethe second-lien lenders feared that a sale ofthe company would leave them with nothing,they also believed that with the benefit of thenew management team and other operationalchanges, there was a realistic chance for agreater return down the road. Accordingly,the second-lien lenders believed that theircollateral had real value if the business couldcontinue as a going concern.

Sixth, none of the parties, or theiradvisors, were sure of how reorganizationsecurities would be dealt with in a chapter 11case (i.e., whether the equity to be issued ina chapter 11 reorganization would beconsidered the proceeds of the first- andsecond-lien lenders’ collateral).

These forces resulted in the negotiationof a pre-bankruptcy lock-up agreement beingentered into by the first- and second-lienlenders. The lock-up agreementcontemplated a chapter 11 filing, a DIP creditfacility geared to providing the debtor withsufficient funds to ensure operations during

the chapter 11 process and a plan that wouldeither allow the company to be reorganizedwith both first- and second-lien lenderssharing in the reorganized company, or a saleof the business should a reasonable goodprospect appear.

The Chapter 11 CaseAtkins Nutritionals filed its chapter 11

case in the Southern District of New York onJuly 31, 2005. At that time, there wasapproximately $300 million in secured debtwith $216 million held by the first-lienlenders and $84 million held by the second-lien lenders. Unsecured trade payablesamounted to about $36 million. Of course,the debtor had the benefit of the pre-negotiated plan represented in the lock-upagreements between the first- and second-lien lenders. What remained was what wouldhappen to general unsecured creditors whostood to get nothing based on the pre-nego-tiated deal.

A series of first-day motions producedthe expected result, and the DIP credit facilitywas approved by the bankruptcy court andput in place. No sale materialized, and thedeal represented by the lock-up agreementwas made the subject of the reorganizationplan. As a result of the creditors’ committeeraising issues arising out of the 2004acquisition and threatening litigation againstthe family of Dr. Atkins, a deal was reachedthat involved the Atkins family funding a 15percent cash dividend for unsecured creditorsin exchange for a release of all claims. First-lien lenders received the right to participatein a new $110 million post-petition creditfacility secured by a first lien on all assets.The remainder of the first-lien debt, and allof the second-lien debt, was converted intoequity in the reorganized debtor. Equityprovided to second-lien lenders andmanagement included special rights thatacted like warrants if the value that could bederived from the business on a sale exceeded$115 million. A management-incentive planwas put in place providing not only for equityownership, but also for bonuses upon thehappening of certain events.

All told, assuming there is value in thestock of the reorganized company, the first-lien lenders received value equal to 100percent of their claim plus the benefit of thepricing and participation in the DIP facility.They also secured the collateral tothemselves alone should the post-chapter 11operations falter and only liquidation valuebe realized. The second-lien positionassuming an $18 million value on thereorganized company stock provided to themrecovered value of approximately 20-25

percent.The future fate of the reorganized

company will bear out whether Atkins worksout for the first- and second-lien lenders. Canit sustain a profitable operation? Will a saleof the business as a going concern be realizedat greater than the $115 million price? Itwould appear at first blush that the second-lien lenders recovered more than they wouldhave had the assets been liquidated in achapter 7 case or even sold as a goingconcern in a §363 sale during the chapter 11case. Ostensibly, any recovery for second-lien lenders must have been at the expenseof the first-lien lenders.5 However, it is fairto say that the chapter 11 process workedsmoothly. Employee jobs were saved. Thefirst-lien lenders continue to earn interest ona reduced first-lien credit facility, both first-and second-lien lenders have a piece of theequity in the reorganized company, andunsecured creditors got an immediate cashdividend.

The more difficult question to answeris this: Why did Atkins work out this way(i.e., with a confirmed chapter 11 plan), whenAmerican Remanufacturers, havingconverted to chapter 7, did not? Were thepolar opposite results a function of the Atkinscredit facility utilizing a single creditagreement, a single security agreement anda single agent? Or was the negotiated-forresult a function of Atkins having significantcross-ownership in the pools of first- andsecond-lien lenders so that the bank group asa whole was oriented to finding the bestpossible return on their investment in bothpools rather than pushing one to thedisadvantage of the other? In the end, onething seems clear: In any bankruptcy, dealingwith limited assets expeditiously willalways be more beneficial than standing onsupposed contractual rights and litigatingwhile the assets continue to decline in value.

Stay tuned. Next month we will discusstwo other recent bankruptcy cases thatinvolved second-lien financing and theresultant inter-creditor issues—the NewWorld Pasta, a.k.a. Ronzoni, and the MaximCrane bankruptcy cases. ■

Reprinted with permission from the ABIJournal, Vol. XXV, No. 4, May 2006.

The American Bankruptcy Institute is amulti-disciplinary, nonpartisan orga-nization devoted to bankruptcy issues. ABIhas more than 11,500 members,representing all facets of the insolvencyfield. For more information, visit ABI Worldat www.abiworld.org.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

5 See Kerr and Rovito, “Second Lien Evolution Creates Higher RecoveryProspects—At First-Lien Lenders’ Expense,” Ratings Direct, Aug. 5, 2005.

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T E

Issues and Information for Today’s Busy Insolvency Professional

Written by:Mark Berman1

Nixon Peabody LLP; [email protected]

Contributing Editor:Jo Ann J. Brighton2

Kennedy Covington Lobdell and HickmanCharlotte, [email protected]

This is the fourth installment in aseries of articles that focus on theparties’ actual experiences in

cases where second-lien financingshave hit the bankruptcy courts.3 In thethird installment printed in the Mayissue of the Journal, we explored the

Atkins Nutritionals,Inc., et al, chapter11 cases.4 Thisfourth installmentexplores the MaximCrane and NewWorld Pasta chapter11 cases.5 As areminder, these re-ports are purelyanecdotal.6 In the

prior installments, we explored howAtkins resulted in a confirmed chapter

11 reorganization plan, a continuingbusiness operation, and both first- andsecond-lien lenders participating in thereorganized company. In contrast,American Remanufactures cratered atthe very start—unable to resolve thedifferences between first- and second-lien lenders on the terms of the debtor-in-possession (DIP) credit facility. Thecase was converted to a chapter 7

liquidation and the assets sold by thechapter 7 trustee. In our view, nobodybenefited by the battle over rightsbetween the first- and second-lienholders contained in the intercreditoragreement.

In this installment,we will see first howMaxim Crane high-lights the potentialbenefits of a nego-tiated resolution viathe bankruptcy pro-cess in contrast tothe strict enforce-ment of the contrac-tual rights found in

intercreditor agreements. Then we willturn our attention to New World Pasta,which illustrates how the crucial early

proceedings in the bankruptcy case mayaffect the ability of the parties toenforce the provisions of theintercreditor agreement at a later time inthe case.

Maxim Crane WorksWhen first reviewing the Maxim

Crane case, the initial question thatcomes to mind, and which has beenposed to these authors, is this: What didthe first-lien lenders do wrong indocumenting the pre-petition creditfacility? After all, the result of theMaxim Crane chapter 11 case was thatthe senior lenders gave up some of theircontractual rights to seniority under theintercreditor agreement and their rightto insist upon application of theabsolute priority rule and allowed valueto flow downhill not only to second-lienlenders (who, given the economics of

the case, would have otherwise receivednothing), but also to unsecuredcreditors. The answer surprises manybankers and nontraditional lenders, butshould not surprise bankruptcyprofessionals who have experience withthe practical realities of the bankruptcyprocess. Very simply, the answer is“nothing.” There was nothing “wrong”with the intercreditor document—norwas there any legal weakness in theposition of the first-lien lenders.Conversations with counsel involved inthe case confirm that the agreement bythe first-lien lenders to allow somevalue to trickle down to the second-lienlenders and unsecured creditors wasinstead driven by their desire to (1) seethe case move along quickly, (2)participate in the DIP loan, (3) receivepayment more quickly (and with morecertainty as to amount) and (4)eliminate risk.

Second-Lien Financings: Good, Bad and Ugly

Feature

About the Authors

Jo Ann Brighton is special counsel withKennedy Covington Lobdell & Hickmanin Charlotte, N.C. She is on the AdvisoryBoard of the ABI Law Review and isBoard Certified in Business BankruptcyLaw by the American Board ofCertification. Mark Berman is a partnerat Nixon Peabody LLP in Boston.

1 Mark Berman’s practice concentrates on bankruptcy law, workouts andcommercial law. He is an active member of the Boston Bar Association,where he chaired its Bankruptcy Law Committee from 1990-92, servedas chair of its Business Law Section from 1995-97, and currentlyserves as a member of its Bankruptcy Section’s Steering Committee.Mr. Berman has taught courses in credit law and business law for theNew England Institute for Credit from 1989-2002 and is currently afacilitator for those same courses taught online on behalf of the NationalAssociation of Credit Management. He served as a member of the ClientSecurity Board for the Commonwealth of Massachusetts from 1997 to2002 and is listed in Woodward and White’s “The Best Lawyers inAmerica” and in Chambers USA’s “America’s Leading Attorneys forBusiness,” each for his expertise in bankruptcy law.

2 Jo Ann Brighton practices primarily in the area of bankruptcy, workoutsand secured lending. She is a co-chair of ABI’s Business ReorganizationCommittee.

3 For the prior installments of this series, see Berman, Mark, Brighton, JoAnn J., “Second Lien Financing: More Questions than Answers,” ABIJournal, Vol. XXV, No. 2 (February 2006); Berman, Mark, Brighton, Jo AnnJ., “Second Lien Financing Part II: Anecdotes: The Good, the Bad, and theVery Ugly,” ABI Journal, Vol. XXV, No. 2 (March 2006); Berman, Mark,Brighton, Jo Ann J., “Second Lien Financing Part III: Anecdotes: The Good,the Bad, and the Very Ugly, ABI Journal, Vol. XXV, No. 4 (May 2006).

4 (Delaware-Case No. 05-200022) (filed 11/7/05) (Judge Walsh). See, also,Berman, Mark, Brighton, Jo Ann J., “Second Lien Financing Anecdotes:The Good, the Bad, and the Very Ugly,” ABI Journal, Vol. XXV, No. 4 (May2006).

5 Parent case was ACR Management LLC et al., No. 04-27848 (W.D. Pa.filed June 14, 2004). In re New World Pasta, No. 04-02817 (M.D. Pa.filed May 10, 2004).

6 The authors reviewed some, but not all, of the pleadings and spoke tosome, but not all, of the parties involved in the case discussed in thisarticle. Our sincere apologies if any information we report in this articleis 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

Jo Ann J. Brighton

Mark N. Berman

To set the stage for this discussion:The debtors, headquartered in Pitts-burgh, constituted North America’slargest crane-rental operation. They hadan assumed enterprise value ofapproximately $475 million. Arrayedagainst that value was debt that totaledabout $700 million. The debt wasdivided into four levels. The senior, orTranche A lenders, were secured by afirst lien on all assets and were owedapproximately $473 million. Tranche Bheld a junior lien on all assets and wasowed about $50 million. Tranche C,also secured by a lien on assets, wasowed $9.1 million. A fourth level ofsecured notes was owed about $190million. Clearly, given the reality of thevalue of the debtor’s assets and thecosts of the reorganization process, nocreditors besides those in Tranche A“should” have received anything.

A pre-negotiated plan had beenagreed upon prior to the debtors’bankruptcy filing. It provided that thefirst-lien lenders would receive a 90percent recovery with some of thatreturn represented by participation in anew secured credit facility and thebalance in most of the equity of thereorganized debtor. The second-lienlenders would receive 9 percent of thecommon stock of the reorganizeddebtor plus warrants. Their recoverywas represented in the disclosurestatement as worth 43 percent of whatthey were owed. The third level ofsecured debt was to receive nothing, butthat level was controlled by the first-lien lenders through an intercreditoragreement. The fourth level of secureddebt was to receive warrants. All of thesecured creditors were to receivereleases. As the bankruptcy processevolved, the first-lien lenders were ableto provide a DIP credit facility thatallowed them to earn additional feesresulting in a greater than 90 percentoverall recovery for the first-lienlenders. A cash recovery and litigationpool was structured for unsecuredcreditors that, depending on thelitigation recoveries, would returnbetween 24 and 50 percent of what theunsecured creditors were owed. Theplan was confirmed six months after thechapter 11 filing, and the reorganizeddebtor emerged from chapter 11 shortlythereafter.

Back to the initial question posed inthis discussion: If the Tranche Alenders were truly senior to the other

lenders and their position was slightlyunderwater, and the intercreditoragreement was enforceable, why wouldthe Tranche A lenders agree to anyrecovery at all for the junior lenders andunsecured creditors? The answer lies inthe first-lien lenders’ recognition ofhow the bankruptcy process works:Time is short, resources are limited,assets are worth what they are worth,and, as the American Remanufacturescase demonstrates, sometimes it doesnot make sense to stand on your rightsand fight for the sake of fighting. Thedisclosure statement reveals the first-lien lenders’ dilemma. While theenterprise value of $475 million meantthat the senior lenders were just a bitunderwater, a chapter 7 liquidation wasprojected to result in a substantial lossof value where the first-lien lenderswould recover only 45 percent of whatthey were owed. It was obvious that thefirst-lien lenders wanted—andneeded—to find a way to realize agoing-concern value and avoidliquidation. To accomplish this goal, thefirst-lien lenders made the decision todistribute some of that enterprise valueto other constituencies but secured tothemselves a sure return of substantialproportion. This made the case arelatively brief one, maintained thegoing-concern value of the business,eliminated any risk that a greater valuemight have been found by the court in acontested valuation dispute atconfirmation, and left them in aposition to enhance that recovery if thereorganized debtors’ equity shouldincrease in value. “[A]bsolute priority isoften merely a theoretical starting pointfrom which the intercreditornegotiations depart.”7 More often thannot, as the Atkins case highlights,parties fare much better when theywork together with a recognition of acommon goal of maximizing recoveryas a whole.

There was simply no reason tobelieve that the intercreditor agreementin Maxim Crane was anything otherthan iron-clad and fully enforceable.However, the Maxim Crane first-lienlenders were faced with the samequandary that most senior lenders facewhen they do not enjoy a recognizedand substantial equity cushion incollateral. Absent a negotiatedagreement, junior secured and

unsecured creditors could use thechapter 11 forum to argue about thevalidity, priority and amount of the first-lien lenders’ secured claims, contest theterms of the DIP credit facility, contestthe valuation of the reorganized debtors,and otherwise cause the chapter 11 caseto be expensive, time consuming andbitter. After all, if the junior creditorsare not allowed to share in the recovery,there is little for them to lose and muchto be gained if they are ultimatelysuccessful (even marginally). Certainly,the first-lien lenders might be able tofight back by trying to stand on theirrights to absolute priority and seek toenforce the terms of the intercreditoragreement. However, it is not clear thata bankruptcy court will take jurisdictionof disputes between secured creditorsover the enforceability of anintercreditor agreement and that wouldleave the senior lenders with nothingmore than a state court breach ofcontract claim to pursue. Furthermore,unsecured creditors are not party to theintercreditor agreement and aretherefore free to raise any of these issueswithout fear of reprisal from the seniorlenders. An enlightened first-lien lenderwill often be eager to limit the length ofthe chapter 11 proceeding, cut down onthe resultant legal and other professionalfees associated with a long andcontentious chapter 11 case, andproduce a result that exceeds whatwould happen in a liquidation. The first-lien lenders also might secure tothemselves the fees that flow from theDIP credit facility, avoid a costlyvaluation fight, obtain post-petitionreleases and secure to themselves thevast majority of the upside representedby control of the equity of thereorganized business.

New World Pasta, a.k.a.Ronzoni

New World Pasta 8 presents adifferent story. It’s another Penn-sylvania case begun about the sametime as Maxim Crane, but this one wasin the Middle District of Pennsylvania.No pre-negotiated plan was pursued.Instead, the debtor came into thechapter 11 proceeding with a proposedDIP credit facility to be provided by thefirst-lien lenders. However, theproposed DIP order contained a clauseto which the second-lien lendersobjected. It provided:

7 Kerr and Rovito, “Second-Lien Evolution Creates Higher RecoveryProspects—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 thepre-petition junior lenders, withrespect to the subordinateobligations, if any, shall only beexercised in a manner consistentwith and subject to the pre-petition credit agreement andpre-petition participation agree-ments.Clearly, the first-lien lenders wanted

the bankruptcy court to order thesecond-lien lenders to abide by theterms of the intercreditor agreements.The second-lien lenders were astute,picked up on the goals of the first-lienlenders and sought to avoid that result.Objections were filed by the juniorlienholders to the motions requestingapproval of the DIP financing, the useof cash collateral and the adequateprotection finding (the “Objections”). Inthe Objections, the junior lienholdersacknowledged that the debtor neededthe post-petition financing on a super-priority basis, but requested that thecourt strike certain provisions of theDIP order as “offending language”since, in the objecting creditors’opinion, that language “potentiallydeprives the pre-petition junior lendersof fundamental bankruptcy rights andprotections that cannot be traded awayin pre-petition agreements to the extentthat [such agreements] purport to doso.”9 The “offending language” hadbeen crafted by the first-lien lenders andplaced into the DIP order in order toenforce provisions of the inter-creditoragreement—namely, a waiver from thepre-petition junior lenders of the rightsto adequate protection and to vote on thechapter 11 plan.10 The Objectionsacknowledged the cases previously citedby these authors concerning theenforceability of certain provisions ofthe intercreditor agreement and arguedthat any order approving the DIPfinancing and authorizing cash collateralshould not be used to obtain declaratoryor injunctive relief on these unsettledissues of the enforceability of waiverprovisions by junior lienholders inbankruptcy cases.11 The Objectionsfurther argued that the enforceability ofthe “offending language” can only beproperly decided as part of an adversaryproceeding.12

The New World court issued a finalorder approving the DIP financing, the

use of cash collateral and the adequate-protection finding (the “order”).13 Itspecifically approved the subordinationof payment of the junior creditors to thesenior creditors.14 However, the finalorder dropped the “offending language”and replaced it with:

38. Pre-petition ParticipationAgreement. Notwithstandinganything in this order to thecontrary, the pre-petition parti-cipation agreements are in fullforce and effect, and nothingherein shall alter, modify, amendor effect the terms andconditions of the pre-petitionparticipation agreements, andnothing herein is or shall bedeemed a waiver of any rights orremedies of the pre-petitionagent or pre-petition seniorlenders thereunder. Nothing inthis order shall be deemed toalter, amend, prejudice or waivethe rights of the pre-petitionsenior lenders or the pre-petitionjunior lenders with respect to thesubordinate obligations underthe pre-petition credit agreementand the pre-petition participationagreements, provided, however,that in the event a court ofappropriate jurisdiction findsthat the pre-petition juniorlenders’ and/or JLL’s agreementsand waivers contained in thepre-petition credit agreementand/or the pre-petition partici-pation agreements are enforce-able, the pre-petition agentpreserves its rights to enforcesuch agreements and waiversretroactively to the petition date,including revoking any pro-tections previously granted tothe pre-petition junior lendersand/or JLL (including, withoutlimitation, those protections con-tained in that certain stipulationand Agreed Interim Orderentered by this court on May 10,2004, and any final order enteredwith respect thereto), whichprotections upon such revocationshall be deemed void ab initioand of no force and effect.There is no reported decision that

explains the basis for the court’s order.

Counsel involved in the dispute haveshared that the objections filed by thesecond-lien lenders were resolvedconsensually. Specifically, the“offending language,” and anyappearance of approval of theunderlying waivers or injunctive ordeclaratory relief, was removed andreplaced with reservations of rights byall. In other words, the fight wasreserved for a later day.

While the New World Pasta casedoes not answer the question of theenforceability of the waivers and otherconcessions typically found in theintercreditor agreements that ac-company silent second liens, it isinstructive in many ways. First, theorder confirms that there are no clearanswers to the question at hand.Second, the objection filed by thesecond-lien lenders suggests thatapproval of DIP financing, cashcollateral and adequate protection inbankruptcy cases involving pre-petitionfacilities with second liens may beconstrued as a blessing of theunderlying loan documents and thewaivers they contain. The ultimatechange in the language seems to implythat such a conclusion is possible andmay in fact act as an estoppel againstraising the issues later.

Finally, New World Pasta revealswhy the issue of the enforceability ofvarious provisions in intercreditoragreements of bankruptcy cases maynever be resolved in a reporteddecision. These issues are oftenconsensually resolved in the early daysof the case while the debtor hangsprecariously awaiting its DIP financingor resolved in the context of a largersettlement allocating value amongst thevarious levels of debt. As discussedearlier, once a bankruptcy case is filed,time is short: DIP financing andpermission to use cash collateral needto be in place essentially before the caseis filed. In a majority of cases, theborrower/debtor is so highly leveragedthat there is no ability to wage asuccessful priming fight, and DIP creditfacilities provided by the pre-petitionsenior lenders are the only real game intown. Issues need to be resolvedquickly, and no one benefits, not theleast of which the junior lenders, ifprecious time is lost and the borrower’smoney is spent on litigating valuationor intercreditor issues. Settlement isoften in everyone’s best interest. It may

9 See 2004 WL 1484987 at 2.10 Id. at 3.11 Id.12 Id.

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 asuper-priority basis pursuant to 11 U.S.C. §364, (b) use of cashcollateral pursuant to 11 U.S.C. §363 and (c) grant of adequateprotection pursuant to 11 U.S.C. §§363 and 364, entered July 9, 2004.).

14 Id. at 9, 25-26.

be worthwhile for junior lenders tolitigate waivers or assignments of theirright to vote their claims at planconfirmation time and to engage in avaluation fight at that time, but in themeantime, all issues of theenforceability of intercreditorprovisions concerning DIP financing,the use of cash collateral, the right toadequate protection, the release of lienson sales of collateral and the right toseek relief from the automatic stay havefaded into the past. In the meantime,waivers or assignments of the right tovote the claims of the second-lienlenders are becoming increasingly lesscommon in intercreditor agreementsused in second-lien financings. It issimply likely that by the time mostplans are presented for confirmation,most of these issues will have also beenresolved consensually by the parties.

ConclusionIn the end, Maxim Crane was a

simple balance-sheet restructuring inwhich the parties, as in Atkins, agreedto work together. The Tranche Alenders’ recovery of more than 90percent is not bad for any bankruptcycase and avoided the disaster of aliquidation. The second lienholders andunsecured creditors happily received arecovery they would not otherwise beentitled to based on the assumedenterprise value. Even more impressive,Maxim Crane was in and out ofbankruptcy in approximately sixmonths.

New World Pasta also demonstratesthe advantages of settlement. However,first-lien lenders would be wise to try to“shore up” their positions in DIP andcash collateral pleadings (although querywhether such beneficial language wouldbe enforceable if it is buried in thehundreds of pages of first-day pleadingsand the bankruptcy judge has not beenmade aware of the implications of thespecific language blessing theintercreditor agreement). Secondlienholders should carefully review allDIP, cash collateral and adequate-protection motions made early in thecase, as well as the proposed orderssubmitted by debtors and first-lienlenders acting in concert. At the veryleast, junior lienholders should file alimited objection reserving all rights toraise enforceability issues under theprovisions of the intercreditor agreement.

Stay tuned. We pledge to scour thehorizon for other bankruptcy cases that

involved second-lien financings andreport to you on the resultantintercreditor issues. ■

Reprinted with permission from the ABIJournal, Vol. XXV, No. 5, June 2006.

The American Bankruptcy Institute is amulti-disciplinary, nonpartisan orga-nization devoted to bankruptcy issues. ABIhas more than 11,500 members,representing all facets of the insolvencyfield. For more information, visit ABI Worldat www.abiworld.org.

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T E

Issues and Information for Today’s Busy Insolvency Professional

Written by:Mark N. Berman1

Nixon Peabody LLP; [email protected]

Contributing Editor:Jo Ann J. Brighton2

Kennedy Covington Lobdell & HickmanCharlotte, [email protected]

In our past four articles in this series,3

we have explored the relationshipbetween first- and second-lien lenders

and how the structure of that relationship,often embodied in theintercreditor agree-ment, has impactedthe course of a reor-ganization of theborrower. Further, wehave discussed thetensions between thecontractual rights con-tained in the intercre-ditor agreement, the

expectations of the parties and the realityof the bankruptcy process. We now turnour attention to that rarest of com-modities, a court’s written decisionrelevant to the interplay between first andsecond liens.

The decision comes to us in the chapter11 cases of WestPoint Stevens Inc. and itsaffiliates, filed in the Southern District ofNew York on June 1, 2003.4 Judge LauraTaylor Swain of the U.S. District Courtfor the Southern District of New Yorkreversed a decision of the bankruptcycourt that had permitted the securedclaims of the first-lien lenders to besatisfied by the transfer to those first-lien

lenders of minority interests in the equityof the parent of the acquiring company.That minority interest was part of theconsideration paid in the context of the§363 sale of the debtors’ assets. With thefirst-lien lenders thereby paid in full,albeit not in cash, the bankruptcy courthad ordered that the balance of thepurchase price, represented by additionalequity in the parent of the acquiringcompany, could be disbursed to thesecond-lien lenders.5

Background6

WestPoint Stevens Inc. and itsaffiliates entered the chapter 11 worldburdened with first- and second-lien debt.Unable to reach agreement with their

creditor constituencies over the terms ofa consensual reorganization plan andunable to refinance or otherwiserestructure the DIP credit facility, thedebtors decided to proceed with a §363sale of all of their assets. The initial bidwas put forward by a sub-group of thefirst-lien lenders led by Wilbur Ross, Jr.A competing bid was put forward by CarlIcahn, who held a majority of the second-lien debt and a minority of the first-liendebt. The Icahn bid prevailed, and thebankruptcy court entered a sale orderauthorizing the debtors’ assets to be soldfree and clear of liens. However, theIcahn bid and the resultant sale orderwere by no means your run-of-the-millsale documents. Rather, while the bidincluded a substantial amount of cash andthe assumption of substantial liabilities,it also proposed that a portion of the

purchase price was to be paid in the formof unregistered equity securities andunregistered subscription rights to thestock of the acquirer’s parent corporation.

The cash was ear-marked to pay downthe DIP credit facilityand the equity se-curities, and sub-scription rights wereto be distributed tothe first- and second-lien lenders. How-ever, this is where itgets interesting: The

Ichan bid required that the equitysecurities and subscription rights bevalued, that the first- and second-lienlenders’ claims be fixed in amount andthat the equity securities and subscriptionrights be distributed to the two lendergroups such that the first-lien lenders’secured claims would be fully satisfied

Second-Lien Financing: Part V: Who Gets What?

Feature

About the Authors

Jo Ann Brighton is special counsel withKennedy Covington Lobdell & Hickmanin Charlotte, N.C. She is on the AdvisoryBoard of the ABI Law Review and isBoard Certified in Business BankruptcyLaw by the American Board ofCertification. Mark Berman is a partnerat Nixon Peabody LLP in Boston.

1 Mark Berman’s practice concentrates on bankruptcy law, workouts andcommercial law. He is an active member of the Boston Bar Association,where he chaired its Bankruptcy Law Committee from 1990-92, servedas chair of its Business Law Section from 1995-97, and where hecurrently serves as a member of its Bankruptcy Section’s SteeringCommittee. Mr. Berman has taught courses in credit law and businesslaw for the New England Institute for Credit from 1989-2002 and iscurrently a facilitator for those same courses taught online on behalf ofthe National Association of Credit Management. He served as a memberof the Client Security Board for the Commonwealth of Massachusettsfrom 1997-2002 and is listed in Woodward and White’s The BestLawyers in America and in Chambers USA’s America’s LeadingAttorneys for Business, each for his expertise in bankruptcy law.

2 Jo Ann Brighton practices primarily in the area of bankruptcy, workoutsand secured lending. She is a co-chair of ABI’s Business ReorganizationCommittee.

3 For the prior installments of this series, see Berman, Mark and Brighton,Jo Ann J., “Second-Lien Financing: More Questions than Answers,”American Bankruptcy Institute Journal, Vol. XXV, No. 2 (February 2006);Berman, Mark and Brighton, Jo Ann J., “Second-Lien Financing Part II:Anecdotes: The Good, the Bad and the Very Ugly,” American BankruptcyInstitute Journal, Vol. XXV, No. 2 (March 2006); Berman, Mark andBrighton, Jo Ann J., “Second-Lien Financing Part III Anecdotes: TheGood, the Bad and the Very Ugly,” American Bankruptcy InstituteJournal, Vol. XXV, No. 4 (May 2006); Berman, Mark and Brighton, JoAnn J., “Second-Lien Financing Part IV: Anecdotes: The Good, the Badand the Very Ugly,” American Bankruptcy Institute Journal, Vol. XXV, No.4 (June 2006).

4 The cases are being jointly administered under docket #03-13532.5 In re WestPoint Stevens Inc., 333 B.R. 30 (S,D.N.Y. 2005).6 As we have with our other articles in this series, we have talked to

some but not all of the parties active in the cases to try to understandwhat motivated them and their view of the other side’s position or of thecourt’s ruling. While we have tried to be accurate, but offer our sincereapologies if any of the information is inaccurate or if any of themotivations about which we speculate are misstated.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

Jo Ann J. Brighton

Mark N. Berman

by their receipt of a portion of the equitysecurities and subscription rights (witha value as determined by the bankruptcycourt) equal in amount to the first-lienlenders’ allowed claims. The balance ofthe equity securities and subscriptionrights were to be distributed to thesecond-lien lenders on account of theirsecured claims.

As one might have expected, the first-lien lenders (other than the Icahninterests) and their agent bank objectedto the proposal that the first-lien claimsbe satisfied with illiquid minority equityinterests in the acquiror’s parent. Whenthe bankruptcy court overruled theirobjections and entered the sale order, theyappealed. As a result of agreementsreached prior to the district court’sdecision, the sale was closed, the liensheld by the first- and second-lien lenderswere transferred to the equity securitiesthat comprised part of the purchase price,and those equity securities were beingheld in escrow.

Bankruptcy Court AnalysisThe first-lien lenders’ credit agreement

contained the usual provisions requiringthat the debtors make payments to the first-lien lenders in cash or immediatelyavailable funds. It also provided that“amounts” collected after an event ofdefault were to be distributed first to thefirst-lien lenders, and then any surplus towhomever was entitled by law. Theintercreditor agreement permitteddistributions to the second-lien lenders inlimited circumstances. There wereprovisions for “Permitted Mandatory Pre-payments,” “Adequate Protection” pay-ments and “Payments to be Made Pursuantto a Confirmed Plan of Reorganization.”Finding the use of the word “amounts”rather than “cash” significant, and notingthat the relevant clause using the word“amounts” was introduced by the words“notwithstanding any other provisions ofthis credit agreement,” the bankruptcycourt found that the documents anticipatedthe possibility that the first-lien lenders’secured claims could be satisfied bysomething other than cash and permittedthose claims to be paid in full by an in-kinddistribution of equity securities valued inan amount equal to the allowed amount ofthe first-lien claims, with the balance of thesale consideration distributed to thesecond-lien lenders.

District Court AnalysisIn reversing the opinion of the

bankruptcy court, the district court

emphasized that the bankruptcy court-ordered distribution of the sale proceedsto the first- and second-lien lenders wasnot being accomplished pursuant to areorganization plan, but rather to a §363sale order. The district court could find noauthority in the Bankruptcy Code bywhich the bankruptcy court could order asecured creditor to accept an in-kinddistribution over its objection and directthat the in-kind distribution satisfied theclaims of the secured lender in full. JudgeSwain also examined the first-lien creditagreement and the intercreditoragreement that had been entered intobetween the first- and second-lien lendersand rejected each of the argumentsproffered by the second-lien lenders forwhy they could force an in-kindsatisfaction of the first-lien lenders’secured claims.7

Document AnalysisInterestingly, the district court looked

to the terms of the same first-lien creditagreement and intercreditor agreementas had the bankruptcy court, but came tothe opposite conclusion. In the districtcourt’s view, the documents did notauthorize the distribution of any portionof the purchase price to the second-lienlenders until the first-lien lenders werepaid in full and in cash. The use of theword “amounts” in the context of thefirst-lien credit agreement’s discussionof how anything received after an eventof default should be distributed did notsuggest to the district court, as it had tothe bankruptcy court, a willingness bythe first-lien lenders to accept paymentin any form other than cash. Further,while the lower court determined that theintercreditor agreement’s “mandatorypre-payment provision” could beinterpreted to authorize the distributionof stock to the first-lien lenders insatisfaction of their senior claims, thedistrict court found that it was overriddenby the credit agreement betweenWestPoint Stevens and the firstlienholders.8 Moreover, while theintercreditor agreement contemplatedthat adequate protection payments couldbe distributed to the second-lien lenders,the district court could not find in §§362or 363 of the Code any authority thatwould permit adequate protection to beutilized as a basis upon which to satisfya senior leinholder’s claims in-kind.Specifically, the district court stated:

The bankruptcy court pointed tono authority, nor has this courtdespite the extensive researchefforts of counsel and theundersigned’s own chambersfound any, standing for theproposition that an action inpermanent derogation of a seniorcreditor’s contractual rights can beforced upon that creditor for thepurpose of providing “adequateprotection” to a junior creditor....

Taken to its logical extreme, thebankruptcy court’s notion of adequateprotection would allow a powerfulcreditor and a debtor anxious to achievesome value for its favored constituenciesto run roughshod over disfavoredcreditors’ rights....”9

The district court also rejected thebankruptcy court’s reliance on theprovision of the intercreditor agreementthat permitted payments to the second-lien lenders pursuant to a confirmed plan.Quite simply, there was no confirmedplan in the case. Since the proposeddistributions were being made under a§363 sale order, the district courtconcluded that the provision was notapplicable to the facts in dispute.10

Statutory AnalysisThe district court also explored the

statutory basis the bankruptcy court hadutilized in entering the sale order, lookingto §§363 and 105 to see whether the Codewould permit the in-kind transfer of anyof the purchase price to the second-lienlenders before the first-lien lenders werepaid in full and in cash. In the districtcourt’s opinion, §363 provided no suchauthority. While §363 authorized thetransfer of the debtors’ property free andclear of liens, there was nothing in §363that permitted the impairment of therights of the first-lien lenders to be paidin cash. The district court noted that theprovisions of §363 applicable to salesprior to a plan are not a substitute for theconfirmation provisions of a plan in§1129. It also distinguished cases cited bythe second-lien lenders as supporting thenotion that secured creditors can be paidin full prior to confirmation of a plan bydistributions received in the sale of estateassets. In the district court’s opinion, thecited cases could not help the second-lienlenders here because the cases allinvolved distributions of cash while theattempt in this case was to satisfy therequirments in-kind and over the secured

7 333 B.R. at 30.8 333 B.R at 44-46. See, also, Dzikowski, “Battle of WestPoint,” The

Secured Debt Report, Vol. II, No. 10, May 21, 2006.

9 Id. at 49-50.10 333 B.R. at 50-51.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

creditors’ objection. The district courtalso gave little credence to the §105argument because there was no provisionof the Code that the §105 power wasbeing employed to advance.11

In the end, the district court found thatoutside of the context of a planconfirmation and assuming such isrequired in the applicable creditagreement, a first-lien lender has a rightto be paid in full and in cash beforeproceeds of its collateral can be disbursedover its objection to junior creditors. Thedistrict court remanded the case back tothe bankruptcy court.12

What Is a Second-Lien Lenderto Do?

It is axiomatic that in bankruptcy allthings flow from value. If there is valuein the collateral in excess of what isowed to the first-lien lenders, thensecond-lien lenders should be able tofind a way to realize that value.However, when that value is representedby illiquid equity securities received inconsideration of the sale of the collateral,there are obstacles to be overcome.Assuming there is true value in theilliquid equity securities over and abovewhat is necessary to satisfy theadministrative expenses of the case andto satisfy the claims of senior creditors,second-lien lenders can generally reachthe value in the illiquid equity securitiesin one of three ways. First, if thecollateral is sold, second-lien lendersshould have their junior liens transferredto the proceeds as a form of adequateprotection. The value of the juniorinterests in the collateral can be reachedwhen those proceeds are ultimatelydistributed to creditors. The distributioncan be effectuated by agreement of theparties via a chapter 7 case to which thechapter 11 is converted after the §363sale has been concluded or through aliquidating chapter 11 plan.

Second, second-lien lenders caneschew a sale, perhaps having to resistefforts by the first-lien lenders to forceone, and work to structure a liquidationor reorganization utilizing the rightsafforded in §1129 of the Code. Eitherway, the second lienholders will have toundergo a valuation battle with the first-lien lenders. If the second lienholders opt

for the reorganization, they mayultimately end up converting some or allof their junior lien claims into equity inthe reorganized debtor and may requiresome additional investment by thesecond-lien lenders into the reorganizeddebtor. This route also poses the problemof what to do with unsecured creditors.

Third, it is not uncommon for anintercreditor agreement being negotiatedin today’s marketplace to afford thesecond-lien lenders the right to purchasethe first-lien lenders’ secured claims atpar. Assuming there is value in thecollateral beyond what is owed to thefirst-lien lenders and the second-lienlenders want to protect that value,purchasing the first-lien position mayclear the way for the second-lien lendersto proceed in whatever way they believeis in their best interests.

Finally, keeping in mind thediscussions contained in other articles inthis series in the context of cases likeAtkins Nutritionals and Maxim Crane, aconsensual resolution, if possible, may bethe best alternative for the first- andsecond lienholders. Second lienholdersmay be best served by using the leveragethey possess based on their ability to slowdown the chapter 11 process to negotiatefor a consensual payment that they maynot have received otherwise because thecollateral value is insufficient.

The WestPoint Stevens chapter 11cases present an interesting twist on thesealternatives. The collateral is sold, but notfor cash that can be easily distributed tothe lienholders providing them with thevalue to which they are entitled. Instead,the purchase price is paid in an illiquidform—in these cases, in the form ofequity of the parent of the acquiringentity. Based on the district court’sdecision, second-lien lenders do not havethe option of forcing first-lien lenders toaccept by way of distribution, at the timeof the §363 sale, a portion of thatpurchase price and realizing the balancefor themselves. Instead, they will eitherhave to allow the illiquid equity to be soldand then see a distribution of the cashproceeds received over an above what isnecessary to satisfy the first-lien lendersin full, or consider how to structure areorganization plan/liquidation builtaround that illiquid equity.

Conclusion and PracticalLessons

The simple fact that the bankruptcycourt and the district court reviewed the

same provisions in the credit andintercreditor documents and thenreached opposite conclusions serves asa lesson to first- and second lienholdersto make sure that the negotiated dealbetween the parties is clearly drafted andconsistent with other provisions in theunderlying credit documents. Spe-cifically, the bankruptcy court foundlanguage in the first-lien creditagreement and intercreditor agreementthat it viewed as authorizing, in thecontext of a §363 sale, the satisfactionof a senior lender’s secured claim witha portion of the purchase price composedof minority equity interests in anacquiring company and then thedistribution of the balance of thatpurchase price to second-lien lenders.The district court reached the oppositeconclusion viewing the exact samelanguage. Accordingly, the business dealin the context of a bankruptcyliquidation must be clearly set forth atthe time the documents are drafted andnot considered for the first time when abankruptcy is contemplated. As is truein all documentation interpretation andas is highlighted in these cases,ambiguity in any form can lend itself tovarying interpretations and results. In theend, one clear lesson from the WestPointcases is that the provisions of theunderlying credit agreement cannot beinconsistent with those contained in theintercreditor agreement or, as theWestPoint cases highlight, the inter-creditor agreement may override specificprovisions of the first-lien creditagreement (and arguably vice versa).Therefore, while first-lien lenders needto be careful in drafting the first-liencredit agreement and intercreditoragreement, and in harmonizing the two,second-lien lenders need to review theunderlying first-lien credit agreementand consider the ramifications of itsprovisions on the negotiated dealbetween the parties as well. ■

Reprinted with permission from the ABIJournal, Vol. XXV, No. 6, July/August 2006.

The American Bankruptcy Institute is amulti-disciplinary, nonpartisan orga-nization devoted to bankruptcy issues. ABIhas more than 11,500 members,representing all facets of the insolvencyfield. For more information, visit ABI Worldat www.abiworld.org.11 Id. at 53-55.

12 It is the authors’ understanding that the bankruptcy court has orderedthat the illiquid equity securities of the parent of the acquiring company,until now held in escrow and impressed with the replacement liens ofthe first- and second-lien lenders, should now be sold at auction in aUCC foreclosure sale context. That decision has now found its way onappeal to Judge Swain.

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T E

Issues and Information for Today’s Busy Insolvency Professional

Written by:Mark N. BermanNixon Peabody LLP; [email protected]

Jo Ann J. BrightonKennedy Covington Lobdell & Hickman LLPCharlotte, [email protected]

Most of the previous articles inour series on second-lienfinancings1 have dealt with the

intercreditor agreement. The last fewarticles have focused on hedge funds that

invest at variouslevels of a company’scapital structure—including by second-lien loans secured bya junior lien on theassets of theborrower—but whichclaims are otherwisenot subordinated. Inthis article we look at

a features of some, but not all,intercreditor agreements. Intercreditoragreements used in second lien financingsare far from uniform and tend to evolveas deals do. When drafting or negotiatingintercreditor agreements, we often areconfronted with the question concerning

how to deal with the debt or equitysecurities that might be issued under areorganization plan.

The situation is complicated because se-cond-lien financings have expanded be-yond their initial context. It is nowcommon for a traditional mezzaninelender to pick up a junior or second lienon the borrower’s collateral and,therefore, become required to enter intoan intercreditor agreement with theholder of the senior or first lien.However, mixing mezzanine financingconcepts with second-lien financingconcepts can prove tricky. Mezzanineand other unsecured financings utilizesubordination agreements thatcontemplate debt subordination as wellas lien subordination. Accordingly,subordination provisions morecommonly found in mezzanine and

other unsecured note or bond indentureshave appeared in second-lien financings.

This article will focus on one suchprovision: the X-Clause. What happensto debt or equity securities that areissued pursuant to a chapter 11reorganization plan on account of asubordinated claim? Especially inmiddle-market and club deals, it iscommon for the intercreditor agreementin second-lien financings to contain avariant of the X-Clause permitting thesecond-lien lenders to retain“reorganization securities” issued tocreditors in a chapter 11 reorganizationcase pursuant to a confirmedreorganization plan. The problem is that(like many of the other provisions wehave discussed in prior articles that areoften included in intercreditoragreements), the X-Clause has not been

litigated in the context of a second-lienfinancing to fully predict the outcomeof its application.

What Is an X-Clause?Whenever multiplelevels of debt areissued by a borrower,there is a need toidentify the rights ofeach debt holder vís-a-vís each otherdebtholder. In the

context of second-lien financings, therights are set out in the intercreditoragreement (assuming separate creditagreements). In unsecured financings, therights are set out in the indenture. As a

The Dura Decision: Junior Creditors AgainStrike Out Interpreting the Elusive X-ClauseWhat Might This Mean for Second-Lien Financings?

Lien on Me

About the Authors

Mark Berman is a partner at NixonPeabody LLP, resident in its Boston andNew York City offices, where his practiceconcentrates on bankruptcy law,workouts and commercial law. Jo AnnBrighton is special counsel with KennedyCovington Lobdell & Hickman inCharlotte, N.C., in its Financial ServicesDepartment - Financial RestructuringGroup, where she practices primarily inthe area of bankruptcy, workouts andsecured lending.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

Jo Ann J. Brighton

Mark N. Berman

1 For the prior installments of this series, see Berman, Mark and Brighton,Jo Ann J., “Second-Lien Financings: Enforcement of IntercreditorAgreements in Bankruptcy—Part I: More Questions than Answers,”American Bankruptcy Institute Journal, Vol. XXV, No. 1 (February 2006);Berman, Mark and Brighton, Jo Ann J., “Second-Lien Financings Part II:Anecdotes and Speculation—the Good, the Bad, and the Ugly,”American Bankruptcy Institute Journal, Vol. XXV, No. 2 (March 2006);Berman, Mark and Brighton, Jo Ann J., “Second-Lien Financings PartIII: Anecdotes—the Good, the Bad and the Ugly: Atkins—the Good,”American Bankruptcy Institute Journal, Vol. XXV, No. 4 (May 2006);Berman, Mark and Brighton, Jo Ann J., “Second-Lien Financings: Good,Bad and Ugly,” American Bankruptcy Institute Journal, Vol. XXV, No. 5(June 2006); Berman, Mark and Brighton, Jo Ann J., “Hedge Funds:Lessons Learned from the Radnor Decision,” American BankruptcyInstitute Journal, Vol. XXVI, No. 1 (February 2007); Berman, Mark andBrighton, Jo Ann J., “Will the Sunlight of Disclosure Chill Hedge Funds?The Tale of Northwest Airlines,” American Bankruptcy Institute Journal,Vol. XXVI, No. 4 (May 2007).

general rule, the subordination provisionsin either document are clearly written. Forsecond-lien financings, the proceeds ofcollateral go first to the first lien lendersuntil they have been paid in full and incash before collateral proceeds can bedistributed to the second-lien lenders—applying the concept of liensubordination. For unsecured financings,senior debt gets paid in full before juniordebt gets anything. The X-Clauserepresents an exception to this generalrule. As it has been explained by thecourts, the X-Clause can be defined asfollows:

Such clauses are common in bonddebentures, although there is nostandard wording. Without theclause, the subordination agree-ment that it qualifies wouldrequire the junior creditors to turnover to the senior creditors anysecurities that they had receivedas a distribution in reorganization,unless the senior creditor has beenpaid in full. Then, presumably, ifthe senior creditors obtained fullpayment by liquidating some ofthe securities that had been turnedover, the remaining securitieswould be turned back over to thejunior creditors. The X Clauseshortcuts this cumbersomeprocedure and enhances themarketability of the securitiesreceived by the junior creditors,since their right to possess (asdistinct from pocket the proceedsof) the securities is uninterrupted.2

The X-Clause is often coupled with adefinition of the types of plan securitiesthat can be issued under a reorganizationplan and that can be held by the creditorburdened by the subordination. Whetherthose securities are denominated“permitted junior securities” as in theDura Automotive case,3 or “reorgani-zation securities” as in many intercreditoragreements used in second-lienfinancings, the purpose of the X-Clauseis to allow certain types of debt or equitysecurities to be issued to the juniorcreditor even though the senior creditorhas not been paid in full as of the time ofthe distribution of the securities.

The Dura Automotive DecisionDura Automotive Systems Inc. and

a number of affiliated entities enteredchapter 11 on Oct. 30, 2006, in the U.S.Bankruptcy Court for the SouthernDistrict of New York.4 Dura’s capitalstructure reflected several levels ofdebt, including a loan secured by asenior lien on substantially all assets,another loan secured by a junior lienon the same collateral and severalissues of notes (all unsecured), butsome denominated senior notes andothers denominated subordinated notes.The subordinated note indenturesincluded the following rather typicalclauses:

Section 10.01 Agreement to Sub-ordinateThe company agrees, and eachholder by accepting a note agrees,that the indebtedness evidencedby the note is subordinated inright of payment, to the extentand in the manner provided in thisArticle 10, to the prior payment infull of all senior debt of thecompany, including senior debtincurred after the date of thisindenture, and that the subor-dination is for the benefit of theholders of senior debt.Section 10.02 Liquidation; Dis-solution; BankruptcyUpon any distribution to creditorsof the company in a liquidation ordissolution of the company, in abankruptcy, reorganization, insol-vency, receivership or similarproceeding relating to thecompany or its property, in anassignment for the benefit ofcreditors or in any marshalling ofthe company’s assets and lia-bilities:

(i) holders of senior debt shallbe entitled to receive paymentin full of all obligations due inrespect of such senior debt(including interest after thecommencement of any suchproceeding at the ratespecified in the applicablesenior debt) before holders ofthe notes shall be entitled toreceive any payment withrespect to the notes (exceptthat holders may receive (i)permitted junior securities and(ii) payments and otherdistributions made from any

defeasance trust createdpursuant to section 8.01hereof); and(ii) until all obligations withrespect to senior debt (asprovided in subsection (i)above) are paid in full, anydistribution to which holderswould be entitled but for thisArticle 10 shall be made tothe holders of senior debt(except that holders of notesmay receive (i) permittedjunior securities and (ii)payments and other distri-butions made from anydefeasance trust createdpursuant to section 8.01hereof), as their interests mayappear.

“Permitted junior securities” means:(1) equity interests in the com-pany, DASI or any guarantor; or(2) debt securities that aresubordinated to all senior debtand any debt securities issued inexchange for senior debt tosubstantially the same extent as,or to a greater extent than, thenotes and the guaranties aresubordinated to senior debt underthis Indenture.In the reorganization plan Dura

proposed, it provided that the holders ofthe senior notes and other unsecuredcreditors would receive new commonstock in the reorganized debtors andwould also have the right to participate ina rights offering. However, as to theholders of the subordinated notes, thedistributions that would otherwise havebeen allocated to them were, inaccordance with the X-Clause of thesubordinated note indentures, reallocatedto the holders of senior debt. Even withthis redirection, the holders of seniornotes were not to receive payment in fullon their claims.

Certain holders of the subordinatednotes5 objected to the plan and filed anadversary proceeding (the objectingnoteholders) in which they asserted that theplan improperly excluded them from alldistributions and recovery. The objectingnoteholders sought a declaration that theplan violated applicable law by failing toprovide a distribution of new commonstock to the holders of the subordinatednotes and by failing to allow them toparticipate in the rights offering. The

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

2 In re Environdyne Industries Inc., 29 F.3d 301, 306 (7th Cir. 1994),quote repeated in In re PWS Holding Corp. et al., 228 F. 3d 224, 244(3rd Cir. 2000). A similar explanation can be found in Deutsche Bank AGet al. v. Metromedia Fiber Network Inc.et al. (In re Metromedia FiberNetwork Inc.), 416 F. 3d 136, 139-140 (2nd Cir. 2005).

3 Dura Automotive Systems Inc. et. al., 2007 W.L. 4302091 (Bankr.D. Del). 4 Id.

5 The objecting holders of the subordinated notes had purchased theirnotes at a substantial discount to par, but Judge Carey mentioned in hisdecision that he did not consider this fact relevant.

objecting noteholders hoped that the courtwould find that any plan that proposed todistribute stock in the reorganized companyto an unsecured creditor must provide a prorata distribution of the stock to the holdersof the subordinated notes. The issue was,therefore, focused on how to interpret theX-Clause and more specifically the definedterm “permitted junior securities.”

In his Dec, 7, 2007 decision,Bankruptcy Judge Kevin J. Carey, rulingon cross-motions for summary judgment,held that the X-Clause, when read in thecontext of the subordination provisionsof the subordinated notes indenture,required that the distribution of commonstock in the reorganized debtor and theright to participate in the rights offeringwere properly distributable to the holdersof senior debt.6

Envirodyne, PWS Holding Corp.,Metromedia and Adelphia

Dura is not the first case to deal withthe interpretation of an X-Clause in asubordinated note indenture. Judge Careyconsidered the issue in the shadow of thedecision of the U.S. Bankruptcy Court forthe Northern District of Illinois in theEnvirodyne case,7 which was affirmed bythe Seventh Circuit in a decision authoredby Judge Posner.8 Envirodyne, in turn,formed the basis for the decision of ChiefJudge Becker writing for the Third Circuitin the PWS Holding case.9 Each of thesecases was in turn cited by the SecondCircuit when it examined the issue in theMetromedia case.10

In Envirodyne and PWS, the courtswere faced, as was Judge Carey, with anX-Clause that appeared from the wordsand grammar used in the X-Clause itselfto allow subordinated noteholders theright to retain new common stock issuedby the reorganized debtor. In other words,the plain meaning of the X-Clauseappeared to favor the argument of thesubordinated creditor. However, bothcourts found that the wording of the X-Clause had to be interpreted in the contextof the entire subordinated note indenturein which it was unmistakably clear thatsubordinated debt was junior to seniordebt and that senior debt had to be paidin full before subordinated debt would beallowed to receive any distribution. In this

broader context, the court determined thatthe X-Clause represented an exception tothe general rule and, in the eyes of thecourts, the reading being put forth by thesubordinated creditors made “no senseonce the context of the terminology beinginterpreted is restored.”11 Accordingly, inthe opinions of both courts, the X-Clausehad to be read as allowing the distributionof securities to the subordinatednoteholders only if those securities werealso subordinated to the rights of thesenior noteholders. In the hands of thesubordinated debt holders, the commonstock and the right to participate in therights offering would not be subordinatedin any way to the rights of the senior debt.Therefore, the common stock and theright to participate in the rights offeringdid not fall within the X-Clause carve-out for equity interests and had to bedistributed to the holders of senior debt.

The ReasoningIn Envirodyne, PWS and Metromedia,

the courts wrestled with what appeared tobe a poorly drafted X-Clause.12 JudgeCarey referred to the Dura X-Clause asfalling “somewhere outside of the realmof utter clarity, yet not quite in the regionof ambiguity.”13 By putting the phrase “tosubstantially the same extent as, or to agreater extent than, the notes and theguaranties are subordinated to senior debtunder this indenture” after the referenceto debt securities and separated from thereference to equity securities, theargument can and has been repeatedlymade by junior noteholders that therestriction modifies only the phrase “debtsecurities” and not “equity securities,”(i.e., if the debt securities aresubordinated to senior debt then they canbe distributed under a plan tosubordinated noteholders but thatlimitation does not apply to equitysecurities). Trotting out the “plainmeaning” rule of both contract andstatutory interpretation, the subordinatednoteholders argue that the language of theX-Clause is clear and unambiguous.

However, each court ultimately ruledagainst the subordinated noteholders inspite of the apparent plain meaning of theX-Clause. To do so, the courts looked atthe X-Clause in the context of the entireagreement of which it was a part.Similarly, in his memorandum opinionin Dura, Judge Carey observed:

“Considering the X-Clause beforeme, I conclude that it must not beconsidered based on its grammaticalstructure alone, but also within thecontext of the entire agreement,which here is more reflective of theparties’ intent: that except in verylimited circumstances, no paymentcan be made to the SubordinatedNoteholders until (1) the seniornotes are paid in full, or (2) thesenior noteholders consent. Tointerpret the X-Clause to include thenew common stock and the rightsoffering in the definition of“permitted junior securities” wouldeviscerate the purpose of thesubordination provision in thesubordinated notes indenture andexpand the limited carve-outbeyond its intended scope.”14

Interestingly, Judge Carey also notedthat the interpretation of the X-Clausesuggested by the subordinated note-holders defied explanation and logicbecause a “senior creditor simply wouldnot agree to a subordination agreement inwhich its priority depended upon the formof consideration chosen by the debtor.15

The Adelphia case presented the XClause issue in a slightly different way.The holders of the subordinated debt (thesub debt, joined by the sub debt trustee)filed a complaint seeking a pre-confirmation declaratory judgment fromthe U.S. Bankruptcy Court for theSouthern District of New York as towhether the sub debt indenture’s generalrule—providing for sub debt to pay overto senior debt any distributions receivedfrom the debtors on the sub debt until thesenior debt was paid in full—wasapplicable when the currency by whichthe plan distribution was made was stockrather than cash or debt securities.16 Thecreditors’ committee and the senior debtindenture trustee moved to dismiss theadversary proceeding initiated by the subdebt on the basis that it failed to satisfythe case or controversy requirements andwas otherwise not ripe for judicialaction.17 The court agreed with theobjection and dismissed the case.18 In thecourt’s determination, the controversypresented in the adversary was too“contingent and speculative.”19 The courtfound it persuasive that the reor-

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

6 Memorandum Opinion, Case. No. 06-11202 (Bankr. D. Del.), Carey,Kevin J. (12/7/07).

7 In re Envirodyne Industries Inc. et al., 161 B.R. 440 (Bankr. N.D. Ill. 1993).

8 29 F.3d 301 (7th Cir. 1994).9 In re PWS Holding Corp., 228 F.3d 224 (3d Cir. 2000).10 Deutsche Bank AG et al. v. Metromedia Fiber Network Inc. et al. (In re

Metromedia Fiber Network Inc.), 416 F. 3d 136, 139-140 (2d Cir. 2005).

11 Envirodyne at 305.12 See Envirodyne at 306.13 Memorandum Opinion at 20.

14 Memorandum Opinion at 20-21.15 Id. at 21.16 In re Adelphia Communications Corp., 307 B.R. 432 (Bankr.

S.D.N.Y. 2004).17 Id. at 434-35.18 Id.19 Id. at 438.

ganization plan had not yet beenconfirmed and that it was “at leastpossible” that the plan could beamended.20 The court also noted that “allparties agree that the concerns voiced bythe sub debt holders would be a soundbasis for an objection to confirmationand, if upheld by the court, would barconfirmation.”21 The court also stated thatit “understands, and is sympathetic to,the points made by the sub debtholdersthat an early ruling might facilitate theirnegotiations, that they would know betterwhat litigation positions they might wishto take if they knew what the outcomewould be in the controversy and that theefforts on the part of the debtor toconfirm what would turn out to be anunconfirmable plan would be time-consuming and costly.”22 However, it wasthe court’s determination that itssympathy and understanding wasinsufficient to confer subject matter todetermine, preconfirmation, the properinterpretation of the X-Clause.23

The court noted that counsel for subdebtholders stated, with “refreshing”candor:

The harm is that we are left in anuntenable, ridiculous position ofnot knowing how to take anyother position in the case. Wedon’t know what to do becausewe don’t know whether we’repari passu creditors, whetherwe’re subordinated creditors, wedon’t know whether we’re senioror junior. We don’t know wherewe stand on certain issues. Wecan take a position on things andsort of cover every base, try tocover, you know, all angles. Butthat’s not easy to do because ourviews may change and may bevery different if we are paripassu, they may be very differentif we’re junior. And it puts us in avery difficult and untenableposition not to know where westand in this case, Your Honor.Arg. Tr. 55.24

The Adelphia case highlights how apoorly drafted X-Clause can eat up estateresources, create confusion, make plannegotiations more difficult and delay theconfirmation of plan by leaving partiesuncertain who is entitled to reorganizationsecurities.

Relevance to Second-LienFinancings

So why discuss this issue in an articleappearing in a series on second-lienfinancings? As stated earlier, provisionsdealing with a second-lien lender’s rightto retain debt or equity securities issuedpursuant to a reorganization plan havebeen appearing with some frequency inthe intercreditor agreements present inthe marketplace for second-lienfinancings. The clause that provides thisright is often borrowed fromsubordinated note indentures and usuallypermits the second-lien lender to retaindebt or equity securities issued under areorganization plan as long as thesecurities continue to be subordinated tothe securities issued to the first-lienlender. Proper draftsmanship is requiredand must be given attention.

Note, however, that while it may beperfectly clear to courts examining an X-Clause in the context of an unsecurednote indenture that subordinatednoteholders should not be able to receiveand hold common equity in thereorganized debtor without consent fromor payment in full of the senior debt, theissue of whether the second-lien lendersshould be able to receive and hold equitysecurities issued pursuant to areorganization plan is simply not assimple or as clear. Remember that thehallmark of a second-lien financing islien subordination and not debtsubordination. Therefore, no one wouldargue with the proposition that if thedistribution of debt or equity securitiesunder a reorganization plan is made onaccount of the second-lien lender’scollateral, the distribution is properlysubordinated to the rights of the first-lienlender. But what if the distribution canarguably be attributed to something otherthan the second-lien lenders’ collateral?After all, the usual context is that thecollateral is not being liquidated and thebusiness of the debtor is continuing. Thesituation is ripe for the second-lienlenders to argue that the foundation ofthe subordination at play in theEnvirodyne, PWS Holding Corp.,Metromedia and Dura cases, specificallysubordination amongst unsecurednoteholders where debt subordinationwas the rule, is not applicable to second-lien financings where only liensubordination is taking place.

ConclusionDraftsmen of second-lien intercreditor

agreements beware! There is yet anotherissue lurking on the horizon. Will second-lien lenders be able to effectively arguethat they should be able to retainreorganization securities issued under areorganization plan? Proper attention tothe issue when the intercreditoragreement is drafted and before the firstdollar is loaned is the only solution. Afterall, the ultimate resting place forreorganization securities should be theproduct of the business deal between thefirst and second-lien lenders. However, ifthe intercreditor agreement fails toaddress reorganization securities orshould it address the issue withoutemploying carefully drafted language todo so, the parties are likely to end up inlitigation. Further, the X-Clause is yetanother area in the second-lien arenawhere practitioners need to manage theexpectations of their clients to a realisticlevel. Practitioners should note that thereasoning in Dura and its predecessorsmay not be applicable to cases where liensubordination rather than debtsubordination is the basis for theagreement between senior and juniorlenders. n

Reprinted with permission from the ABIJournal, Vol. XXV, No. 2, March 2008.

The American Bankruptcy Institute is amulti-disciplinary, nonpartisan organizationdevoted to bankruptcy issues. ABI has morethan 11,500 members, representing allfacets of the insolvency field. For moreinformation, visit ABI World atwww.abiworld.org.

44 Canal Center Plaza, Suite 404 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

20 Id. at 438-39.21 Id. at 439-440.22 Id. at 440.23 Id. at 440-41.24 Id. at 441, fn. 26.