Is the Future Secure for Second Lien Lenders in Europe?

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1 LEGAL ANALYSIS: [2007] J.I.B.L.R. 443 the principle of equity is consistent with Islamic teachings. With due respect, these statement flawed. This case is important since it focuses on the aspect of Islamic banking facility after the controversial case of Affin Bank Bhd v Zulkifli Abdullah. 2 Such an observation should not be swept under the carpet. The learned judge must provide an exhaustive elaboration on the principles of equity in Islam. Simply equating the Islamic teachings and principle of equity is not acceptable since the principle of equity in Islam is wide and not only limited to the contractual obligation. (3) The element of riba Even though the loan facility granted is an Islamic loan, a calculation of sale price employed by the bank is, unfortunately, akin to conventional loan formula. Fixing of a sale price based on an agreed profit rate to balance with the tenure and amount of the facility may give an impression that a similar mode of calculating interest (riba) adopted by conventional loan is being employed in determining the ultimate sale price. On such basis, the court employed a standard approach in differentiating the sale price as earned and unearned profit for unexpired tenure of the Islamic principle of Bai Bithamin Ajil. In reality, the formula employed by the bank is unjust as it leads to exploitation and injustice which is completely forbidden in Islam. Imam Al Ghazali, the great Muslim scholar has clearly stated that Riba is prohibited because it prevents people from undertaking real economic activity. Is the Future Secure for Second Lien Lenders in Europe? Clive Wells * and Neil Devaney Bankruptcy proceedings; Comparative law; Debts; Liens; Schemes of arrangement; United States Second lien financings continue to be increasingly popular in the United States, with deal volumes reaching $27.9 billion during 2006, 1 and have gained a strong foothold in Europe, with almost 3 billion raised in the third quarter of 2006 alone. 2 Originally thought of as transitional or rescue capital, second lien debt has truly come of age in the United States and now makes up a significant segment of the US capital markets, accounting for approximately 8 per cent of total institutional issuance and nearly 5 per cent of total leveraged loan issuance during However, while the European market has imported the second lien concept from the United States, it has not strictly followed the US model. With no harmonised European insolvency regime and the existence of a healthy mezzanine market, there is currently no standard form for second lien financings in Europe. While investors have clearly developed an appetite for stretching the capital structure of European companies with second lien debt (with ever increasing leverage levels), it is less clear how, or even if, the product will eventually settle down this side of the Atlantic. European second lien has little history of restructuring or workout as yet and the lack of predictable cross-border insolvency laws or a consistent capital structure is likely to lead to varying recovery rates in a default scenario. This article compares some of the main structural features of the European and US second lien debt and looks to the future for investors in this relatively new addition to the European debt market. What is second lien debt? Second lien debt is, as the name suggests, debt that benefits principally from the same security as secured senior debt, on a second ranking basis. The senior (first lien) lenders and second lien lenders agree that on enforcement of the security, the senior lenders will be paid in full from the realisation proceeds before the second lien lenders receive anything. The 2. [2006] 1 CLJ 438 HC. * Clive Wells is a Leveraged Finance Partner and Neil Devaney is an Associate in the Corporate Restructuring Department at Skadden, Arps, Slate, Meagher & Flom (UK) LLP. 1. Source: Reuters LPC. 2. Source: Fitch. 3. Source: Reuters LPC.

2 444 LEGAL ANALYSIS: [2007] J.I.B.L.R. second lien debt may be in the form of a loan or bonds and is typically lent or issued at the same level in the borrower s corporate group as the senior debt. It can be documented in a separate facility or merely as a separate tranche of the senior secured debt. While second ranking security is not new in Europe, second lien debt differs from traditional European mezzanine in that the repayment rights of the second lien lender are not normally contractually subordinated to those of the senior lender (in the way that a European mezzanine lender s rights would be). While some of the initial European second lien deals featured contractual subordination, as well as prioritisation of proceeds on enforcement of security, this has not been present in the more recent European deals. What is the attraction? Price and flexibility are the two key factors attracting borrowers to second lien deals. Although more expensive than senior bank debt, second lien debt in the United States and Europe continues to be significantly less expensive than traditional mezzanine loans. While price varies with risk profile (and there is not yet a typical use for the second lien in Europe), European second lien is typically priced between 400 and 700bps, against 11,000bps or more for certain mezzanine products. The other principal attraction for borrowers is that second lien debt tends to have greater prepayment flexibility than other forms of junior debt. While a plain vanilla 10-year high yield bond would typically be non-callable for five years (and then attract penalties for a further three), and prepayment of mezzanine would often attract penalties in years one to three, second lien debt may often be prepaid at par or with a modest premium after the first year. This flexibility is also attractive to funds investing in Europe with short term or event driven strategies. Secured, unsubordinated debt is attractive to lenders. Secured second lien lenders gain certain rights to influence any insolvency process (although, as explained below, these are normally waived to some extent) and, importantly, will rank ahead of the general body of creditors on any insolvent distribution of assets (to the extent of the value in secured assets once the senior lender have been paid). Further, the US institutional investors and hedge funds that are unable to invest in contractually subordinated debt are attracted to second lien debt as the lender is only subordinated on enforcement of security. US institutions are highly liquid and very familiar with the second lien concept, due to the burgeoning US market. Hedge funds have grown significantly in the United States and Europe in recent years and their contribution to the leveraged buyout (LBO) market on both sides of the Atlantic is on the rise. While senior banks have traditionally been averse to sharing their collateral with junior creditors, the increased liquidity and leverage levels in the market has led to a wider acceptance of second lien financings and the reduced exposure that they offer the senior creditor. The US perspective Second lien loans originally developed in the United States as a way of providing rescue capital to distressed companies, partly in reaction to the economic downturn in the early 2000s. Historically, they provided a method of refinancing for companies that had little access to traditional capital sources. Proceeds were primarily used to pay off maturing debt, provide interim liquidity or reduce bank debt leverage. However, US lenders current preference for asset-based lending (and, more recently, enterprise value lending) over cash flow lending has contributed to the explosion of the US second lien debt market. As lenders and borrowers have become more comfortable with second liens, they are being used more often and in a broader range of applications, particularly in the LBO market. US second lien loans have been developed to appeal to US institutional investors that cannot participate in subordinated debt and are typically lent at the same level as a senior asset-based loan. They will usually contain the same covenants and repayment rights as the senior loans (although second lien bonds will have no maintenance covenants or cross default provisions). The senior and second lien lenders will agree that on enforcement of security, the senior bank has the right to be repaid in full first. In the United States, the senior lender cannot normally block payment to the second lien lenders in the event of a default, but the second lien lenders will waive some of their secured creditor rights, for example, by agreeing only to take unilateral action to enforce their security in certain circumstances. The extent to which second lien lenders surrender these rights results in the debt being referred to as either quiet or silent (see box below on Structuring Second Lien in Europe). Second lien in Europe The bulk of the European second lien financings to date have been in the United Kingdom and Germany, although second lien issuances by French satellite operator Eutelsat ( 475 million) and Italian telecommunications company Wind ( 700 million) represent two significant exceptions. While second lien issuance is increasingly being used to finance primary LBOs (for example, the in-financing acquisition of Gala Group), the overwhelming majority of the European second lien deals continue to form part of a refinancing or recapitalisation (indeed, Gala Group s second lien debt was refinanced in September 2005,

3 LEGAL ANALYSIS: [2007] J.I.B.L.R. 445 barely six months after it was put in place, to allow the payment of a substantial dividend to the funds of the equity sponsors, Candover and Cinven). Second lien debt has yet to show a consistent structure in Europe. As with the US high yield, differences in the market conditions and legal frameworks in Europe have caused lenders to significantly adapt the US second lien debt model to take into account the different insolvency regimes and the dominant influence of senior bank lenders in Europe (see box below on Structuring Second Lien in Europe). Saturated junior debt market? One reason why the second lien concept may be struggling to settle down in Europe is the presence of an existing healthy junior debt market, with 14.6 billion of mezzanine debt being raised in the third quarter of 2006 and 32 billion of high yield (compared with 3 billion of second lien debt for the same period). 4 In the United States, companies do not traditionally grant security to mezzanine investors, and so the market for second ranking secured debt was relatively untapped until recent years. On insolvency, the US second lien lenders now fit comfortably into the debt structure, ranking behind senior secured debt, but ahead of the unsecured and contractually subordinated mezzanine lenders and high yield bond holders. US senior lenders have become comfortable with the reduced exposure offered by a new class of second ranking secured debt. European mezzanine, on the other hand, although usually contractually subordinated through an intercreditor agreement (although in some jurisdictions structural subordination is required/preferred), typically benefits from second ranking security over the assets of the borrower. European senior banks often already have the reduced exposure offered by a second ranking secured debt, but that debt is also usually contractually (or structurally) subordinated. It can then be seen that many second lien deals in the European market closely resemble European mezzanine. Typically, the second lien debt is used either instead of mezzanine debt, or it sits below the senior debt and above mezzanine or bonds in the capital structure, with the latter demoted to thirdpriority debt (typically referred to as a stretched senior structure). Where second lien debt has been used as a substitute for mezzanine debt, the price differential between the two products has narrowed in recent deals, and may mean that the market for this type of quasi-mezzanine debt is limited. Whilst there continues to be a marked difference in the pricing of stretched senior deals and traditional mezzanine products (and so continued demand from borrowers), going forward, these deals will depend on the appetite of high yield or traditional mezzanine 4. Source: Fitch. investors to accept third-ranking security. Although European high yield bonds are usually structurally and contractually subordinated to senior debt, unlike European mezzanine, high yield debt is traditionally unsecured in Europe (although bondholders have increasingly sought upstream guarantees and security in recent deals) and so the opportunity for second lien growth in this area may be greater than in the loan market. With a burgeoning junior debt market, the use of the second lien product in Europe continues to be somewhat opportunistic. The use of second lien debt in Bain Capital s acquisition of Brenntag was reported as representing a reaction to senior debt syndication problems, rather than a strategy to use a different product, for example. The product has also provided companies with limited access to traditional capital sources, or limited time, a method of refinancing their debts. For instance, distressed German manufacturing company Treofan was able to restructure its debt profile in a very short timeframe by the issuance of 170 million of second lien notes in July of last year. Uncertain recovery? The growing number of countries and industries participating in the European loan market and the complexity of transaction structures, not least as a result of the prevalence of second lien lending, makes the landscape for both issuers and investors increasingly unfamiliar. The lack of harmonised insolvency and financial collateral laws and policy between the various Member States may further limit the potential for second lien deals in Europe and restrict recoveries in distressed situations. Along with inconsistencies in the structure of second lien deals and increasing leveraged ratios, the unpredictability of restructurings in Europe has led ratings agencies to often ascribe very low recovery ratings to second lien debt. For example, 25 out of the 26 second lien deals rated by Fitch during the third quarter of 2006 achieved 5 or 6 out of 6 (with 1 being best) on likely recoveries in a default/distress situation. Second lien debt is normally secured against enterprise value and intangible assets, lent on the theory that the company has more value locked in their assets or enterprise than the senior lender is prepared to advance. If a borrower becomes insolvent, the business must usually be maintained as a going concern for the second lien lender to recover its exposure. While Chapter 11 provides a predictable, debtorfriendly bankruptcy regime in the United States, focused on the rescue of the company as a going concern, many European insolvency regimes are orientated towards liquidation or receivership. In addition, it is difficult to take effective asset security in a number of European jurisdictions, often requiring the lender to have actual possession the assets secured. Although the EU Regulation on Insolvency Proceedings (1346/2000) and the Collateral Directive

4 446 LEGAL ANALYSIS: [2007] J.I.B.L.R. (2002/47) have addressed some European insolvency conflicts of laws issues, the unpredictable nature of individual bankruptcy in Europe regimes and difficulties in perfecting security in certain jurisdictions have traditionally led European creditors to set up complex security packages at the outset of deals and favour out-of-court consensual restructuring arrangements where a borrowing company fails. Investors in European second lien debt must understand what security is available in each jurisdiction and what will happen to that security if the borrower becomes insolvent. While traditional mezzanine investors are more familiar with these issues, they have generally been reluctant to divert funds to a lower yielding asset. If second lien loans continue to resemble European mezzanine debt, it is difficult to see why second lien lenders would recover more than a traditional mezzanine bank in a distressed situation, which then begs the question as to why second lien loans are so cheap and if they secure. Conclusion Although mezzanine and high yield markets are currently buoyant in Europe, investor liquidity has never been higher across Europe. Financial sponsors continue to pursue ambitious purchase prices and traditional LBO debt markets are being stretched. Capital continues to flow into hedge funds, which along with US institutions continue to look for new investment opportunities. The option of a cheap, technically unsubordinated, secure loan that can be refinanced in the short term is attractive to these funds, and to borrowers. Nevertheless, the lack of predictable cross-border insolvency laws in Europe and inconsistencies in the structure of second liens is likely to lead to varying recovery rates in a distressed or default scenario. With little history of restructuring or workout of the complex European capital structures involving second lien debts, if the market continues to pursue its counterintuitive cycle of higher risk and lower pricing, the future may be less than secure for investors in second lien debt in Europe. Structuring Second Lien in Europe There is not yet a typical use for the second lien concept in the European market, but in deciding how the second lien debt fits into the capital structure, finance parties need to consider the following issues: Inter-creditor arrangements In Europe, the relationship between the finance parties will generally be governed by an intercreditor agreement, even where the second lien facility is documented as a tranche of the senior debt. This document will be heavily negotiated as it determines how the priority of the second lien debt and the rights the senior lender will have to enforce payment blockage or standstill provisions. Although there is no standard form in the United States, the finance parties relationship will normally be more straightforward than in Europe, but will often be set out in a inter-creditor document, nevertheless. Turnover provisions The US model provides for turnover only of monies received through security enforcement or liquidation, allowing investment by funds that are prohibited from participating in contractually subordinated debt. In Europe, deals have ranged from contractual obligations to turn over only monies received through security enforcement to provisions requiring turnover of all monies received whatever the source. Waiver of secured creditor rights Second lien lenders will usually agree to waive or limit (normally for a specified time) typical secured creditors rights. For example, they will remit their rights to exercise remedies against the secured assets and will not participate in decisions relating to the dealing with or sale of assets (including decisions relating to appropriate price or buyer). In addition, second lien lenders will agree not to challenge the validity, priority or enforcement of the senior security. The second lien debt is referred to as silent where these provisions continue until the senior debt is repaid in full, or quiet where they only continue for limited standstill periods. Second lien loans are normally quiet, while bonds tend to be silent. Voting rights Finance parties should also consider what voting rights are afforded to the second lien lender during the lifetime of the debt, particularly where the second lien debt is documented as a separate tranche of the senior loan agreement. The negotiating strength of the parties will generally

5 LEGAL ANALYSIS: [2007] J.I.B.L.R. 447 determine the extent to which the second lien lenders are able to vote on usual matters (not including enforcement action). Payment blockage and standstill provisions Fundamental differences in the US and European insolvency regimes result in completely opposite approaches to payment blockage provisions (where payments to the second lien lender are blocked while a senior default exists) and standstill provisions (where the second lien lender is prevented from taking enforcement action while senior default continues). Because the subordination of second lien debt relates only to security and not to the debt claim itself, payment blockage and standstill provisions are absent in the US market. Senior lenders in the United States rely on the statutory moratorium under c.11 to allow the borrower not to make payments and prevent the second lien lender from taking enforcing action. The lack of harmonised insolvency laws in Europe and often unpredictable bankruptcy regimes of individual countries has resulted in European creditors favouring out-of-court consensual restructurings. As a result, European second lien deals will almost always contain payment blockage provisions and standstill periods to allow a debtor to conserve cash whilst stakeholders consider restructuring options. These provisions are a standard feature of mezzanine and high yield lending in Europe. Mezzanine deals typically contain provisions for 90 days for a payment default, 120 days for a financial covenant default and 150/180 days for any other default, while high yield deals usually provide for 179 days for payment defaults. Second lien deals vary. Where the debt is in place of mezzanine, it is likely that the payment blockage and standstill provisions would follow standard mezzanine facilities, i.e. 90, 120, 150/180. However, where a second lien tranche sits between senior and mezzanine, second lien lenders may benefit from slightly shorter periods than the mezzanine lenders. Life Insurance Assignment, Insurable Interest, Trust and Insurance Regulatory and Development Authority (IRDA) StandonInsurers Dharmesh Srivastava * and Santanu Roy ** Assignment; India; Life insurance; Mortgages In India, insurance dates back to Ever since, this sector has been considered a booming market with every other global insurance company wants to have a decent share in the Indian insurance market. Even though, life and general insurance in India is still a promising sector, with the coming of the following public and private players into the Indian market, the insurance sector in India has gone through a number of radical changes. Life Insurance Players Public Life Insurance Corporation of India Private Aviva Life Insurance (Aviva has more than 364 billion of assets under management). Birla SunLife Insurance (Sun Life Financial Group had total assets under management of C$446 billion). Bajaj Allianz Life Insurance (Allianz has insured most of the world s largest infrastructure projects which include Hong Kong Airport and Channel Tunnel). Bharti AXA (AXA had 1,091 billion in assets under management as of June 30, 2006). HDFC Standard Life Insurance (Standard Life s worldwide life and pensions sales in quarter to March stood at 3,915 million. And its India, China and Hong Kong JV sales were estimated to be at 87 million). ING Vysya Life Insurance (The ING Group, Exide Industries, Gujrat Ambuja Cement and Enam Group are Vysya s partners and the ING Group has over $1 trillion in assets). * Dharmesh Srivastava is a Partner at FoxMandal Little, Solicitors & Advocates and he may be reached at dharmesh.srivastava@foxmandallittle.com/dharmeshsri vastava@yahoo.com ** Santanu Roy is a commercial lawyer at FoxMandal Little, Solicitors & Advocates and he may be reached at santanu.roy@foxmandallittle.com/kolkata.legal@gmail.com.