Advanced Distressed Investing Concept

Grant, a member of the Distressed Debt Investors Club and guest contributor here writes a piece on the advanced distressed investing concept of intercreditor issues. Enjoy:

A feature of the last credit cycle was the growth of 2^nd lien financing. While structures involving bank debt, high yield bonds, and/or mezzanine loans also involve inter-creditor considerations, many 1^stlien/2^nd lien agreements exhibit less standardization than for more traditional structures. Especially when considering rights, recoveries and remedies in a bankruptcy scenario for 1^st or 2^nd lien instruments where both senior and junior liens exist, developing a view of how the bankruptcy court will likely interpret and enforce the provisions of an inter-creditor agreement can be critical.

In a 2^nd lien financing, the 1^st lien lender and the 2^nd lien lender share in the same collateral, with the latter receiving liens junior to the former. The inter-creditor agreement covers (1) subordination of claims and liens and (2) certain waivers of rights by the 2^nd lien lender both inside and outside bankruptcy. While the focus of this post shall be specific to bankruptcy waivers, waivers under non-bankruptcy law are also extremely important and can have serious implications within as well as outside of bankruptcy. See Buena Vista Home Entertainment, Inc. v. Wachovia Bank, N.A. (In re Musicland Holding Corp.),374 B.R. 113 (S.D.N.Y. 2007) for a particularly serious example of a 2^nd lien creditor suffering from a bankruptcy court’s interpretation of a general consent granted by the 2^nd lien lenders in an inter-creditor agreement.

The bankruptcy courts have not always enforced bankruptcy waivers as consistently as many creditors perhaps would have liked: BRC§510(a) states “a subordination agreement is enforceable in a case [in bankruptcy] to the same extent that such agreement is enforceable under non-bankruptcy law.” However, some courts have held that the Bankruptcy Code mandates subordination is distinct from certain statutory rights creditors receive through the bankruptcy process that cannot be altered through pre-bankruptcy negotiations and waivers. Some important bankruptcy waivers include:

1. Adequate protection
• 2^nd lien lender waives right to oppose adequate protection for 1^st lien lender.
• 2^nd lien lender waives right to seek adequate protection for itself.

Issue: BRC§361 provides three methods to provide adequate protection of a secured party’s interest in property to compensate for declines in the value of collateral: 1) cash payments, 2) replacement liens, or 3) the “indubitable equivalent” of the collateral. With a junior lien, declines in the value of the collateral will impair the 2^nd lien instrument’s value first. Especially for collateral that declines rapidly in value, these waivers can constitute a significant risk for the 2^nd lien holders, especially in longer-duration bankruptcy cases. Strict enforcement of this waiver could leave the 2^nd lien holder severely under-secured, with only a general unsecured deficiency claim for the remaining balance of the loan.

2. Use of cash collateral
• 2^nd lien lender consents in advance to, and/or waives objection to, use of cash collateral if 1^st lien lender approves.

Issue: Cash collateral is money earned from the sale of assets against which a lender has a lien, and the lender retains liens against these cash proceeds unless the bankruptcy court approves their use by the debtor. Particularly for asset-based loans secured by floating liens against receivables and inventory, the debtor will likely generate significant cash collateral as it collects pre-petition accounts receivable and sells pre-petition inventories. An over-secured 1^st lien lender has little incentive to protect a 2^nd lien lender’s lien in cash collateral and may support, or decline to object to, the debtor’s use of cash collateral. That action, especially when combined with a waiver of adequate protection, again would leave the 2^nd lien lender unsecured with only a general unsecured claim for the deficiency.

3. DIP financing
• 2^nd lien lender consents in advance to, and waives right to object to, DIP financing approved by 1^st lien lender and priming liens granted in favor of DIP lender.

Issue: DIP financing can be authorized by the bankruptcy court, which will grant a priming lien senior to existing pre-petition liens if (1) the debtor is otherwise unable to obtain such credit and (2) the existing lien holder remains adequately protected. Consider a scenario where there is a 1^st lien claim for $50M, a 2^nd lien claim for $40M, and the collateral is worth $80M. Without a priming lien, there is 100% recovery to the 1st lien creditor and 75% recovery to the 2^nd lien creditor. Now consider a $30M DIP facility combined with an enforceable waiver against the 2^nd lien creditor causing such creditor to lose the right to oppose the DIP loan. The 1^st lien creditor still enjoys 100% recovery, while the 2^nd lien creditor’s recovery drops from 75% to 0%. Often, the 1^st lien pre-petition lender is also the DIP financing provider, so will have an incentive to prime the 2^nd lien holder, especially if the 1^st lien lender is receiving large fees from providing the DIP facility and/or other benefits afforded to DIP lenders such as a roll-up of pre-petition debt.

4. Lien release
• 2^nd liens release during bankruptcy.

Issue: Would turn the entire secured claim secured by a junior lien into a general unsecured claim if strictly enforced by the court.

5. Post-petition interest
• 2^nd lien lender waives rights to seek post-petition interest, fees, and expenses.

Issue: When a secured lender is over-secured, BRC§506(b) and case law provide for that lender to collect post-petition interest; and reasonable, contractually-determined fees and expenses, up to the amount which the secured lender is over-secured. In estimating returns to a 2^nd lien instrument that appears over-secured, inability to collect post-petition interest, fees and expenses could have a material impact on return calculations, particularly in longer bankruptcy cases.

6. Sale of collateral
• 2^nd lien lender waives right to object to sale of collateral if 1^st lien lender consents.

Issue: A numerical example illustrates the implications of this waiver. Using the same example as in (3) above, again assume 1^st lien debt of $50M, 2^nd lien debt of $40M, collateral worth $80M. Sale at $80M would yield 100% recovery to 1^st lien creditor, 75% recovery to 2^nd lien creditor. Now assume a “fire sale” of the collateral for $50M to which the 2^nd lien creditor cannot object: The result is a 100% recovery to the 1^st lien creditor, who is indifferent to whether sale occurs at $50M or any value above that amount, but a 0% recovery to the 2^nd lien holder.

7. BRC§1111(b) elections
• 2^nd lien lender waives rights to make BRC§1111(b) election without consent of the 1^st lien lender.

Issue: The BRC§1111(b) election allows a secured claimant to have its entire claim, to the extent allowed, treated as a secured claim instead of having it bifurcated into a secured and an unsecured portion, provided the secured party waives any deficiency claim against the estate for the amount which the secured party is under-secured (see BRC§1129(b) for details on the “cram-down” of secured parties). Without getting into extensive detail, this waiver would significantly affect recoveries for a 2^nd lien creditor which is (1) under-secured and (2) expects recoveries for unsecured creditors to be low.

8. Voting rights:
• 2^nd lien lender waives voting rights on a plan of reorganization, or assigns rights to 1^st lien lender.
• 2^nd lien lender waives right to vote for or on the appointment of a trustee.

Issue: The 2^nd lien lender could be forced to vote for a plan that would provide a recovery significantly inferior to the amount to which the lender would be entitled even if “crammed down” in accordance with the provisions of BRC§1129(b).

To reiterate, there are doubts regarding the bankruptcy courts’ enforcement of bankruptcy waivers. One school of thought holds that 1^st lien lenders and 2^nd lien lenders are sophisticated parties, and that the 2^nd lien lender waives rights, including bankruptcy rights, in exchange for a higher yield. However, some courts have held that the US Constitution vests in Congress the right to set uniform laws on the subject of bankruptcies, and that had the “Founding Fathers” intended private parties to pre-determine provisions of bankruptcy law between and among themselves, the Constitution would not have vested such authority in Congress exclusively. This tension has led to case precedents that can seem in conflict with one another. For example, in Bank of America v. North LaSalle Street Ltd. P’ship (In re 203 North LaSalle Street Ltd. P’ship), 246 B.R. 325 (Bankr. N.D. Ill. 2000) and in In re Curtis Ctr. Ltd. P’ship, 192 B.R. 648 (Bankr. E.D. Pa. 1996), bankruptcy courts reached seemingly differing conclusions regarding whether the 2^nd lien lender’s waiver of the right to vote to confirm a plan of reorganization was valid. Other precedents that, on their face, may appear to contradict one another, exist for other bankruptcy waivers.

Furthermore, recent growth of 1^st lien/2^nd lien structure and the attendant proliferation of agreements and disputes regarding such agreements, some issues have not yet been fully adjudicated by the bankruptcy courts. While the “ABA Model Intercreditor Agreement” is a welcome development that may reduce uncertainty for new issues, many distressed analysts are currently considering secondary purchases of the issues that took place during the last decade’s credit expansion that lack standardized clauses and, accordingly, standard interpretations.

For a complete analysis of returns for a security significantly affected by inter-creditor issues, the lack of certainty regarding enforcement of certain clauses means that, while reading the inter-creditor agreement is a necessary first step, making educated guesses, almost certainly assisted by counsel, on how certain of its provisions could be enforced by the bankruptcy court may also become necessary.