Second-lien financings pose bankruptcy risks

Implications: Second-lien financings have been enjoying a meteoric rise in popularity in recent years. They typically involve loans by both senior and junior syndicates to a common borrower, secured by a common collateral pool. Second-lien financing is attractive to borrowers because the second-lien lenders charge lower interest rates than are generally available from mezzanine or high-yield debt lenders, and the second-lien lenders do not receive equity in the form of warrants or a conversion right. They are also attractive to lenders because second-lien loans get a higher rate of interest than the first lien loan, to compensate for the increase in risk, but they also enjoy the security of a junior lien on assets, a feature not available in a mezzanine or high-yield debt deal. The second-lien loan features lien subordination, i.e. the lien securing the second-lien loan is junior in all respects to the lien held by the first lien lender. However, there is no debt subordination as is the case with mezzanine or high-yield debt structures.

 

Analysis: At the heart of a second-lien loan financing is an inter creditor agreement that is entered into by the first and second-lien lenders. The goal of the first lien lender in entering into an inter creditor agreement is to make the second-lien lenders as silent as possible in the event the first lien lender has to take action as a result of a problem with the loan. The first lien lender will want a free hand to work out the troubled credit with the borrower, including the ability to have assets sold to repay the first lien loan. In contrast, the goal of the second-lien lender is to preserve as many rights as possible, to protect the value of the common collateral that will be available. A typical inter-creditor agreement will provide for the express subordination of the second-lien to the first lien, the release of the second-lien lender's lien on collateral if it is sold with the consent of the first lien lender, and provisions to avoid the second-lien lender from making waves in a bankruptcy proceeding of the borrower. The variations are endless, as currently no uniform inter creditor agreement is being used in second-lien financings.

Yet, despite the significant efforts put into negotiating the inter creditor agreement, there is little consensus on whether its terms will hold up in a bankruptcy case. There is scant case law to guide lawyers advising participants in second-lien financings. The few decisions that have been handed down are in conflict. Some courts have been willing to enforce the agreements as written, based upon the freedom of sophisticated lenders to contract away rights and a provision of the Bankruptcy Code that makes subordination agreements enforceable in bankruptcy cases to the same extent they are enforceable outside of a bankruptcy case. However, other courts have questioned whether that provision of the Bankruptcy Code just referred to endorse anything beyond the lien subordination provisions, and thus have invalidated the second-lien holders' assignment of voting rights to the first lien holders regarding a plan of reorganization and the waiver of the right to seek adequate protection for the second-lien interests and relief from the automatic stay if adequate protection is not obtained, even though both were explicitly provided in the inter creditor agreements.

What is clear is that second-lien financings are likely to make Chapter 11 cases much more difficult. Based upon experiences to date, first lien lenders often realize less on the first lien loan in a Chapter 11 case than if there were no second-lien loan present. Conversely, second-lien creditors have been able to secure value in bankruptcy cases beyond what most observers viewed as the true value of collateral in excess of the first lien claims. When you consider that the amendments to the Bankruptcy Code that became effective in 2005 imposed additional burdens on bankruptcy cases that can make them more expensive and difficult to manage (see Nixon Peabody LLP Bankruptcy Law Alert Special Edition-Spring 2005 "New Amendments to Bankruptcy Code: Large Impact on Business Bankruptcies"), the introduction of a second-lien financing structure into the Chapter 11 process is likely to lead to even more expense, delay, and uncertainty.