There is almost no limit to the kinds of structures that companies use SILENT SECOND LIENS

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1 HOWARD SEIFE An increasing number of financings involve silent second liens. There remain some questions, however, as to the enforceability of various provisions typically included in the intercreditor agreements between the first lien holder and the silent second. The better reasoned view, according to Howard Seife, of Chadbourne & Parke LLP, is that the parties to these transactions should be permitted to agree on their terms, and that bankruptcy courts therefore should uphold these agreements. There is almost no limit to the kinds of structures that companies use to finance their operations. Indeed, banks, bank groups and other commercial lenders regularly develop new lending products to meet their customers objectives, while maximizing their own income and limiting their own risk. When all is said and done, however, banks essentially extend credit in one of two ways: on a secured basis, or on an unsecured basis. The Uniform Howard Seife is a partner in Chadbourne & Parke LLP s New York office and chair of the firm s bankruptcy and financial restructuring practice. Mr. Seife, the Bankruptcy for Bankers columnist for The Banking Law Journal, has more than 25 years of experience as a bankruptcy attorney and has represented lenders and other interested parties in reorganizations of retail, technology, energy, real estate, leasing, textiles, manufacturing, telecommunications, and media companies. He has dealt with virtually every bankruptcy situation, including debtor-inpossession financing, cash collateral orders, automatic stay relief, plan negotiation, sales of assets, and preference and fraudulent conveyance actions, and is a leader in the use of cross-border ancillary proceedings. Mr. Seife may be reached at hseife@chadbourne.com. Published in the October 2004 issue of The Banking Law Journal. 771

2 BANKING LAW JOURNAL Commercial Code and the federal Bankruptcy Code establish the basic framework that governs these loans. Whether a particular loan will be secured or unsecured depends, of course, on the relevant market as well as on a wide range of other factors, such as the bank s evaluation of the borrower s financial posture and the borrower s desire to close the deal. Recently, there has been extensive growth in the origination of what has come to be known as silent second lien financings. These loans have significant benefits to first lien holders (often banks or bank groups) as well as to second lien holders and borrowers. Importantly, though, there is some question as to the enforceability of a key aspect of the structure of these financings i.e., the factors that make the second lien silent. After briefly explaining the structure of silent second lien loans, this article examines the leading court decisions analyzing the enforceability, in the event of the borrower s bankruptcy, of certain of the key provisions in the applicable agreements creating silent second liens. This article concludes that the better view is that the parties to these transactions should be permitted to negotiate the terms of their agreements, and that bankruptcy courts therefore should enforce these contracts. THE STRUCTURE In a typical silent second lien transaction, a bank or other lender (or a lending group) takes a first lien on all or substantially all of a borrower s assets. The debt may or may not also be guaranteed by affiliated companies or additionally secured by their assets. The borrower generally has other creditors, including trade and other general unsecured creditors. A lender, consortium, hedge fund, bond group or other investor (acting for itself or perhaps for public or private capital markets) then extends credit to the same borrower, taking a second (or junior ) lien on all or substantially all of the assets on which the first secured creditor has a lien. Although secured creditors often are reluctant to allow second liens on the assets on which they hold primary liens, first lien holders may be persuaded to permit a second lien for a number of reasons. For one thing, this additional financing can decrease the amount of financing the first secured creditor must extend. Moreover, when a second lien loan takes place in an 772

3 out-of-court restructuring or workout, a portion of the new financing may be used to reduce the senior creditor s exposure. Borrowers can benefit from second lien financing, as well. Importantly, secured loans are usually less expensive for borrowers than unsecured credit; that is because creditors rely on the borrower s assets as well as its promise to repay. In some cases, borrowers simply may be unable to raise unsecured funds; a second lien loan avoids that problem. Borrowers also may be able to obtain the additional funding provided by a second lien loan without raising undue concerns among their unsecured creditors because the assets they are pledging to the second lien lenders are already pledged. Additionally, a borrower involved in a workout can offer a second lien to unsecured creditors (such as bond holders) in exchange for their consent to the terms of the restructuring. Certainly, potential lenders also are attracted to the prospect of being secured by a second lien. Secured creditors in a bankruptcy typically recover a greater percentage of their debt than unsecured creditors. Although second lien creditors do not have the primary position on a borrower s collateral, they are in a position that is superior to trade debt and to the borrower s other unsecured creditors including tort and environmental claimants. Another significant reason that lenders prefer a second lien to unsecured status is that secured lenders both in the first and in the second position are afforded important rights under the Bankruptcy Code, including: the right to adequate protection, the potential for post-petition interest on the loan, the right to consent to or object to extensions of credit to a debtor in possession that prime prepetition liens, the right to be heard on the use of cash collateral and on the sale of collateral by the debtor in possession, and the right to be placed into a separate class in a reorganization plan. It also is more difficult for a debtor to cram down a secured creditor (essentially forcing an unwilling creditor to accept a reorganization plan) than it is to cram down an unsecured creditor. 773

4 BANKING LAW JOURNAL THE SILENT SECOND LIEN A second lien that preserved all of the rights described above would not be silent. A second lien becomes a silent second lien when the creditor, in its agreement with the senior lien holder, gives up certain of the rights to which it is otherwise entitled, particularly those rights that it would have in the event of a default by the borrower or in the event of the borrower s bankruptcy. The junior lien holder becomes silent at a time when it otherwise would be able to act to protect its position. Most significantly, the second secured lien holder will often agree, among other things: that it will not object to the validity and enforceability of the first lien holder s security interest, that the senior lien holder will be entitled to proceeds of the collateral until payment in full of its claim before the second secured lien holder receives any proceeds, even if the senior lien is invalidated, to limit its ability to vote on a reorganization plan (e.g., that it will not vote in favor of any plan opposed by the senior secured creditor, or will assign its right to vote on the plan to the senior secured creditor), and to abide by the senior lien holder s positions with respect to adequate protection and use or sale of collateral. These provisions usually are included in an intercreditor agreement between the first and second lien holders. Senior lenders that have the ability to block junior lenders from taking second liens on their collateral very well may not even consider allowing a junior lien in the absence of any of these provisions; in short, they may be essential to obtaining the senior creditor s consent to the second lien transaction. The senior creditor wants to ensure, to the maximum extent possible, that it is in control of the collateral upon the borrower s default or bankruptcy, and that its position will not be negatively affected by any actions (or inaction) of the second lien holder. For its part, the second lien holder may attempt to limit the rights it gives up, or to agree that its rights are limited only for certain time periods or in certain situations. It should be noted that a silent second lien still retains its 774

5 priority over a borrower s unsecured creditors, at least up to the value of its collateral. ENFORCEABILITY OF INTERCREDITOR AGREEMENTS Subordination agreements generally are enforceable, as provided in Bankruptcy Code section 510(a). 1 An intercreditor agreement that establishes the terms of a silent second lien is not exactly the same as a subordination agreement; for example, a subordinated claim is subordinated for purposes of all payments; intercreditor agreements involved in silent second lien transactions usually limit second lien holders receipt of payments from the shared collateral, not from all sources. But the same legal principles that argue in favor of enforcement of subordination agreements would seem to support the enforcement of intercreditor agreements in silent second lien scenarios. Consider the decision several years ago by a Pennsylvania bankruptcy court in In re Curtis Center Limited Partnership. 2 In this case, the debtor was a Pennsylvania limited partnership formed to acquire and renovate an office building in Philadelphia. The renovation was financed in part through a loan from Mellon Bank (East), N.A. The building was further leveraged with a $95 million working capital credit facility extended by Sumitomo Trust and Banking Co. Ltd., New York Branch. Pursuant to a separate agreement, Mellon agreed to subordinate its debt to the debt of Sumitomo. The agreement provided, among other things, that all of Mellon s liens were junior to Sumitomo s in right of payment, including any distribution to be made to Mellon under any plan of reorganization, or from any other source. The agreement also authorized Sumitomo on behalf of Mellon to: file all claims, proofs of debt, petitions, and other documents required in such statutory or non-statutory proceedings for the full outstanding amount of [Mellon s] debt and prove and vote or consent in any proceedings with respect to any and all claims of [Mellon] relating to [Mellon s] debt, in each case as Sumitomo may deem advisable, in its sole discretion. 775

6 BANKING LAW JOURNAL After the debtor defaulted, it entered chapter 11 and thereafter filed a plan of reorganization that placed Sumitomo in one class and Mellon in a second class. The debtor then sought to have the court confirm its plan despite Sumitomo s objection. The court first indicated that it would not even examine whether there was a reasonable basis upon which the debtor could separately classify Mellon s claim. Rather, the court focused on what it characterized as a glaring problem for confirmation purposes: that Sumitomo had repeatedly stressed its right to vote Mellon s claim and that it would vote on Mellon s behalf to reject the plan, thus making it clear that there was no hope that the plan would receive an assenting vote from Mellon. The court said that it was [c]onstrained to agree with Sumitomo, pointing out that the language of the subordination agreement was plain and unambiguous and that the terms of this prepetition agreement were fully enforceable in the debtor s bankruptcy case. Indeed, the court declared, [n]o argument to undercut the efficacy of the subordination agreement or the application of section 510 had been offered. The court therefore ruled that the debtor could not rely on Mellon as its potentially accepting impaired class for purposes of cram down under Bankruptcy Code section 1129(a)(10). THE BROADCASTING CASES Two other decisions, both coincidentally involving broadcasting companies, also support the view that provisions in intercreditor agreements that now typically are included in silent second lien documentation should be enforceable. The issues in In re Inter Urban Broadcasting of Cincinnati, Inc., 3 primarily involved the obligations of the debtor, Inter Urban Broadcasting of Cincinnati, Inc., to Barclays Business Credit, Inc. and to Firstmark Credit Corp. The debtor was indebted to Firstmark when Barclays provided the debtor with an amount of money that was, in part, to pay a portion of the earlier debt. As a condition precedent to Barclays s loan, the debtor, Firstmark and Barclays signed a Subordination and Intercreditor Agreement by which Firstmark assigned and subordinated to Barclays all of its claims, collateral, interests and rights until Barclays was paid in full, including the 776

7 right of Barclays to vote Firstmark s claim in connection with any plan of reorganization. After the debtor entered chapter 11, it and Barclays filed plans of reorganization. In Barclays s plan, the main asset of the estate, a radio station, would be sold, Barclays would receive payment of only a portion of its claim, and Firstmark would receive nothing. Barclays voted its and Firstmark s claims for its plan. The debtor objected to Barclays s plan and moved to disqualify or designate Barclays s votes. The bankruptcy court found: Under the Subordination Agreement with Firstmark, Barclays is granted the right to vote the claim of Firstmark in this bankruptcy case. Firstmark has been given notice of the bankruptcy proceeding, has appeared through its counsel of record, and has raised no objection to Barclays voting of Firstmark s claim. Barclays acceptance of Barclays plan on behalf of Firstmark is consistent with its rights under the Subordination Agreement. The bankruptcy court then denied confirmation of the debtor s plan and confirmed Barclays s plan. The debtor appealed, arguing in essence that, under Bankruptcy Code section 1126(g), 4 Firstmark should have been deemed not to have accepted Barclays s plan because it was not entitled to receive any property on account of its claims. The district court observed that pursuant to the agreement, Firstmark benefited from Barclays making the loans to the debtor and in exchange for that benefit assigned and subordinated all its claims and rights to Barclays. As the district court pointed out, Firstmark held no claim or interest and could not do so unless and until Barclays was paid in full. The district court declared that the only way the debtor could succeed on its section 1126(g) argument was if the agreement should not be enforced. The district court then stated that the debtor neither attacked the agreement nor suggested that it is not enforceable under non-bankruptcy law. Indeed, the district court held, the agreement is enforceable here and the debtor s argument based on section 1126(g) is without merit. Accordingly, it concluded, Barclays s vote on Firstmark s claim was proper and in accord with the law. The situation in In re Davis Broadcasting, Inc. 5 was quite similar. In this 777

8 BANKING LAW JOURNAL case, Broadcast Capital, Inc. and AmeriTrust Company National Association two creditors of the debtor, Davis Broadcasting, Inc. had entered into a Continuing Subordination and Pledge Agreement. Not only did this agreement give AmeriTrust s lien priority over Broadcast s lien, but it also gave AmeriTrust substantial rights in the event of a future default and subsequent bankruptcy. For one thing, Broadcast was prohibited from taking action of any kind to collect or enforce its debt without the written consent of AmeriTrust. The agreement also gave AmeriTrust the right to file a proof of claim and vote on behalf of Broadcast in any bankruptcy proceeding of the debtor. The debtor ultimately entered chapter 11 and AmeriTrust and the debtor entered into a stipulation whereby AmeriTrust agreed to vote its and Broadcast s interests in favor of the debtor s plan, and that it would not for itself or Broadcast file or offer any objections to the plan. At the confirmation hearing, AmeriTrust voted to accept the plan on behalf of itself and Broadcast. Broadcast did not object to the plan and the bankruptcy court entered an order confirming it. Copies of the confirmation order and the confirmed plan were served on Broadcast, which did not appeal the confirmation order. Thereafter, the court signed an order stating that substantial consummation of the confirmed plan had been completed. More than a year later, Broadcast filed a motion to reopen the case and to correct what it characterized as an error in the confirmed plan of reorganization. The debtor objected to Broadcast s motion. It noted that AmeriTrust, on behalf of Broadcast, did not object to the plan but rather voted to accept the plan. The debtor further pointed out that Broadcast itself did not object to the confirmation of the plan and that neither AmeriTrust nor Broadcast appealed the order confirming the plan. The bankruptcy court stated that it had to keep in mind that Broadcast voluntarily had lent money to the debtor and entered into the subordination agreement with AmeriTrust. In essence, the bankruptcy court observed, Broadcast was saying that it should not suffer because AmeriTrust did not protect its interests as it would have preferred but the bankruptcy court emphasized that Broadcast freely entered into the Subordination Agreement that put it into this situation. In other words, the bankruptcy court stated, Broadcast did not want to be held responsible for its own actions. It then rejected Broadcast s motion. 778

9 BANKRUPTCY ACT RULING More than 40 years ago, a federal district court in New York issued a decision broadly upholding the provisions of a subordination agreement. Although the district court s decision was issued under the Bankruptcy Act, the predecessor to today s Bankruptcy Code, the court s reasoning is still applicable today. 6 The case arose after the Dutch-American Mercantile Corporation loaned $50,000 to Itemlab, Inc., and obtained the consent of Blanmill Realty Corporation to the subordination of its indebtedness to Dutch s debt until such time as Dutch was paid in full on its loan. The debtor, Dutch, and Blanmill all executed the agreement. At the time, the debtor was indebted to Blanmill for $87,000 and, in turn, Blanmill was indebted for the same amount to Popkin, the debtor s president. The debtor thereafter filed a petition for an arrangement under chapter XI of the Bankruptcy Act (comparable to a chapter 11 reorganization under the current Bankruptcy Code). Blanmill transferred its claim against the debtor to Popkin, who transferred it to the Commercial Bank of North America as security for a preexisting debt of Popkin to Commercial Bank. Commercial Bank then accepted the plan. Dutch objected to Commercial Bank s acceptance. The referee in bankruptcy sustained the objection and disallowed the bank s acceptance. As a result, the debtor was unable to obtain acceptances by a majority of the creditors in number and amount and, consequently, the debtor was adjudicated as a bankrupt. The dispute reached the United States District Court for the Eastern District of New York. In its decision, the district court said the issue it had to decide was whether Blanmill or Dutch had the right to vote Blanmill s claim for the purpose of approving or disapproving the plan of arrangement. To answer this question, the district court examined the terms and effect of the subordination agreement. As the district court noted, the subordination agreement was a complete subordination agreement that became effective immediately and did not depend on the debtor s insolvency. Its clear intent, the district court continued, was that immediately upon a determination of insolvency and the 779

10 BANKING LAW JOURNAL insufficiency of the assets of the debtor to pay Dutch in full from dividends on both its own claim and Blanmill s claim, the debtor was authorized by Blanmill to pay Blanmill s claim to Dutch. Thus, Dutch became entitled to complete control over the claim, and no further consent was necessary from Blanmill, which no longer had any authority to collect or any power to revoke. In other words, the district court ruled, Dutch was entitled to Blanmill s claim. The district court next analyzed whether Blanmill had the right to vote its claim even though Dutch had the right to collect Blanmill s claim. The court had no problem finding that Dutch indeed had the right to vote Blanmill s claim even though the subordination agreement was silent as to voting of claims in bankruptcy proceedings: Since the vote attached to the claim is the only means of determining how and when the claim shall be enforced and the terms of payment, it would follow that the person entitled to collect the claim should be the person entitled to vote the claim; otherwise the result would be anomalous and would repose in the inferior creditor the power to use his vote to determine how the superior creditor shall collect a claim in which the inferior creditor no longer has an interest. The district court then affirmed the referee s decision. ALTERNATIVE DECISIONS There have been some courts, without a great deal of analysis, that have declined to enforce provisions similar to those typically found in intercreditor agreements dealing with silent second liens. For example, a 1980 decision by a Minnesota bankruptcy court in In re Hart Ski Mfg. Co., Inc., 7 considered a subordination agreement in which Beatrice Foods Co. agreed to subordinate its claim against the debtor to the claim of Aetna Business Credit Inc. After the debtor entered chapter 11, Beatrice filed a complaint seeking either adequate protection or a lifting of the automatic stay. Aetna asserted that Beatrice had no right to seek adequate protection or the lifting of the stay because of the subordination agreement, but the bankruptcy court 780

11 rejected that argument. The bankruptcy court declared that the intent of Bankruptcy Code section 510, regarding the enforceability of subordination agreements, is to allow the consensual and contractual priority of payment to be maintained between creditors among themselves in a bankruptcy. It then simply stated that there was no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets. The rights not related to contract priority of distribution pursuant to section 510(a) cannot be affected by the actions of parties prior to the commencement of a bankruptcy case when such rights did not even exist, the bankruptcy court declared. Without further analysis, it concluded that to hold that, as a result of a subordination agreement, the subordinor gives up all rights to the subordinee would be totally inequitable. A decision by an Illinois bankruptcy court in 2000, reaching the same conclusion as the Minnesota bankruptcy court, contained no better rationale. In In re 203 North LaSalle Street Partnership, 8 a creditor of the debtor entered into an agreement with the Bank of America that contained a broad subordination provision, including an agreement that the bank could vote the creditor s claim in a bankruptcy reorganization. After the debtor entered bankruptcy and proposed a chapter 11 plan, the creditor argued that it had the right to vote its own claim in the confirmation proceedings. The court agreed with the creditor. It stated that although the language of the subordination agreement governed the outcome of the bank s right to repayment, the language of the Bankruptcy Code governed the determination of voting rights in this case. The court pointed out that Bankruptcy Code section 1126(a) provides that the holder of a claim may vote to accept or reject a plan under chapter 11. It then found that the subordination agreement did not provide a basis for disregarding section 1126(a), stating that because bankruptcy is designed to produce a system of reorganization and distribution different from what would obtain under nonbankruptcy law, it would defeat the purposes of the Code to allow parties to provide by contract that the provisions of the Code should not apply. The bankruptcy court then simply declared that section 510(a), in directing enforcement of subordination agreements, does not allow for waiver of voting rights under 1126(a). In the bankruptcy court s view, 781

12 BANKING LAW JOURNAL subordination affects the order of priority of payment of claims in bankruptcy, but not the transfer of voting rights. The court cited the Minnesota bankruptcy court s 1980 decision but did not refer to the decisions highlighted above that reached the opposite result. CONCLUSION When a secured lender agrees to the grant to another lender of a junior lien on the same assets on which it holds a lien, common sense would dictate that the senior lender should be allowed to negotiate the terms with the junior lender and that all of the provisions of that agreement play a role in the senior lender s decision whether or not to permit the junior lien. There is no principled reason to reject a contract reached in good faith by sophisticated parties that ultimately is intended to protect a senior lender s position and establish the terms of the junior lender s claim. Decisions by two bankruptcy courts, two decades apart, both of which failed to cite or analyze decisions that reached the opposite result, should not be the final word on the enforceability of provisions in intercreditor agreements that make second liens truly silent especially given the better reasoned decisions that reached an opposite result. In any event, to minimize the risks that these agreements will not be upheld, senior lien holders must carefully consider the language of their intercreditor agreements to make certain that there is a knowing and conscious waiver of potential bankruptcy rights by the junior lender. Lenders also should recognize that litigation to enforce these agreements ultimately may be required. NOTES 1 11 U.S.C. 510(a) provides: A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law B.R. 648 (Bankr. E.D. Pa. 1996) WL (E.D. La. 1994). 4 Section 1126(g) provides: Notwithstanding any other provision of this section, a class is deemed not to have accepted a plan if such plan provides that the claims or 782

13 interests of such class do not entitle the holders of such claims or interests to receive or retain any property under the plan on account of such claims or interests B.R. 229 (Bankr. M.D. Ga.), rev d on other grounds, 176 B.R. 290 (M.D. Ga. 1994). 6 In re Itemlab, Inc., 197 F. Supp. 194 (E.D.N.Y. 1961). 7 5 B.R. 734 (Bankr. D. Minn. 1980) B.R. 325 (Bankr. N.D. Ill. 2000). 783