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Business Bankruptcy Issues Recent Developments

Second Liens and Intercreditor Agreements: Are Those Bankruptcy Voting Provisions Really Enforceable?

In this post I look at the second lien phenomenon and then discuss an interesting new case addressing whether a fairly common intercreditor agreement provision — giving a senior lender the right to vote a second lien lender’s claim in bankruptcy — will actually be enforced.

Senior Debt And Mezzanine Financing. When a company borrows from a bank, it typically grants the bank a first priority, blanket security interest in all of its assets to secure this senior debt. In the past, when a company needed additional capital, whether to grow the business or to fund an acquisition, it often turned to unsecured "mezzanine" financing, so named to reflect its middle position between senior debt and equity. This type of unsecured debt typically is subject to complete payment subordination in favor of the senior lender and is considerably more expensive than bank debt. 

The Second Lien Market. One of the biggest financing trends in recent years has been the move away from unsecured mezzanine credit to debt secured by a second priority security interest on all of the company’s assets. Much of this "second lien" debt is coming from hedge funds and other private equity funds, although more traditional lenders have also become active in the market. According to CFO.com, the second lien market has grown dramatically over the past several years, from $570 million in 2002 to more than $16 billion in 2005. Some reports suggest it approached $30 billion in 2006. 

Why the attraction to second lien financing? The main reasons are price, terms, and availability. Healthy companies generally find the pricing on second lien credit to be lower than unsecured mezzanine debt (although a bit more expensive than on senior debt) and often comes with few covenants. For distressed companies, if they can obtain additional credit at all, many times it’s as part of a restructuring in which a new lender requires a second lien to protect it from an increased risk of default. 

Subordination and Intercreditor Agreements. Most second liens are blanket security interests and cover the same collateral against which the senior lender has a first lien. Traditionally, senior lenders include provisions in their loan documents prohibiting borrowers from granting security interests or liens to any other lender without the consent of the senior lender. When a lender proposes to make a second lien (also known as a "junior" or "tranche B" loan), it must negotiate not only with the borrower but also with the senior or "tranche A" lender. As the size of the second lien market suggests, senior lenders have been willing to consent to second lien loans, often to help the borrower make an acquisition or to bring in additional liquidity.

  • The negotiations between the first and second lien lenders usually address their respective rights to the collateral and various provisions regarding repayment of their loans. Sometimes the second lien debt will be subordinated to repayment of the senior debt, as with traditional mezzanine financing, but more often only the security interest in the common collateral will be subordinated to that of the senior lender.
  • The senior lender generally insists that the junior lender be a "silent second" and waive rights to object to actions taken by the senior lender in a default or bankruptcy. The junior lender instead wants to have the ability to protect its own interests. The end result often comes out somewhere in between, but restrictions on the second lien lender are common.
  • The arrangements between the senior and second lien lenders are documented in a separate agreement, usually called an intercreditor agreement or a subordination agreement.

Key Intercreditor Agreement Provisions. If everything goes well and the borrower repays its loans on time, the provisions of the intercreditor agreement won’t be all that important. However, if the borrower defaults on the loans, or files for bankruptcy, the terms of the agreement can become critical.

  • With bankruptcy in mind, key provisions negotiated in intercreditor agreements often include waivers or consents by the second lien lender relating to debtor in possession (DIP) financing, use of cash collateral, rights to adequate protection, conduct of a Section 363 sale of the debtor’s assets (i.e., the lenders’ collateral), and the extent to which the senior lender will have the right to vote the second lien lender’s claim on any Chapter 11 bankruptcy plan of reorganization.
  • Section 510(a) of the Bankruptcy Code provides that a "subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." Bankruptcy courts routinely enforce payment subordination provisions in which the junior lender agrees not to receive any payments (or to turn over any that it does receive) until the senior lender is paid in full.

Bankruptcy Voting Provisions. Bankruptcy voting provisions, however, have not always been enforced. Most notably, the court in In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000), held that Section 1126(a) of the Bankruptcy Code, which provides that the "holder of a claim or interest allowed under section 502 of this title may accept or reject a plan," means that only the actual holder of the claim may vote and that an agreement giving that right to the senior lender is not enforceable. Other courts have been more willing to enforce voting provisions in subordination agreements. Still, the issue has not come up very often. Voting provisions have been the subject of reported decisions in only a handful of cases over the past 25 years.

The Aerosol Packaging Decision.  That dearth of authority makes the decision in In re Aerosol Packaging, LLC, issued by a bankruptcy court in Atlanta in late December 2006, of keen interest. (Thanks go to Scott Riddle of the Georgia Bankruptcy Law Blog for first posting on the decision.) In that case, Wachovia Bank was the senior lender under a subordination agreement entered into with Blue Ridge Investors, II, L.P., a second lien lender to the debtor, Aerosol Packaging. In its Chapter 11 bankruptcy, the debtor filed a plan of reorganization acceptable to Wachovia. When votes were solicited, both Wachovia and Blue Ridge submitted competing ballots voting Blue Ridge’s claim, with Wachovia’s ballot accepting the plan’s primary treatment of Blue Ridge’s claim and Blue Ridge’s ballot rejecting that proposed treatment.

  • Blue Ridge then filed a motion seeking a determination of its voting rights and allowance of its ballot instead of the one Wachovia submitted. (For reference, the subordination agreement attached as an exhibit to that motion designates Blue Ridge as the "Subordinated Creditor" and Wachovia, as successor to SouthTrust Bank, as the "Lender.")
  • Wachovia opposed the motion, relying on a section in the subordination agreement that made it, as the Lender, "irrevocably authorized and empowered (in its own name or in the name of the Subordinated Creditor)" to "take such other action (including without limitation voting the Subordinated Debt. . . " as it "deemed necessary or advisable." Wachovia also argued that the In re 203 North LaSalle Street Partnership case, relied on by Blue Ridge, was wrongly decided and that the bankruptcy rules allowed agents to vote another party’s claim. 
  • To complete the picture, the debtor itself also filed a response supporting Wachovia’s position.

In siding with Wachovia, the bankruptcy court held that Wachovia was the agent of Blue Ridge, that under the subordination agreement Blue Ridge assigned its right to vote to Wachovia, and that Section 1126(a) of the Bankruptcy Code does not prohibit the enforcement of such provisions. The court therefore accepted Wachovia’s ballot and rejected the one submitted by Blue Ridge. The court also pointed out that Blue Ridge is not without a remedy: it "may free itself from the ongoing effect of the Subordination Agreement by paying the Wachovia claim in full in cash." Blue Ridge has appealed the decision, so a higher court may have a chance to rule on the issue.

Uncertainty Remains. As only one bankruptcy court ruling, the Aerosol Packaging decision does not settle the issue of whether bankruptcy voting provisions will be enforced. Still, it’s interesting that the court considered and rejected the reasoning of the In re 203 North LaSalle Street Partnership decision. Given that this subordination agreement involved both lien and payment subordination, it’s unclear whether the voting provision would have been enforced if the lenders’ agreement had involved only lien and not payment subordination, which is the more typical second lien arrangement. The answer to that question will have to wait for the next case.

Recent Developments

The “Ask The VC” Blog

Although this blog is focused on Chapter 11 and other business bankruptcy topics, I wanted to draw your attention to a terrific new blog that explores the many issues facing entrepreneurs at the other end of the business life cycle. 

As its name implies, Ask the VC, a new blog by Brad Feld and Jason Mendelson, is devoted to answering the range of questions entrepreneurs have about starting and funding companies, particularly those that are venture backed. Fortunately for its readers, this blog is written by two highly respected and experienced VCs. Among other credits, Brad is a founder of Mobius Venture Capital and Jason is a Mobius Managing Director. Both are also founders of an early stage venture capital fund called Foundry Group. Their new blog, along with another of their collaborations, the widely read Feld Thoughts, offers keen insights into the formation, financing, and growth of new companies. I highly recommend it.

Recent Developments

New Bankruptcy Resource: The Absolute Priority Newsletter

As a member of the Bankruptcy & Restructuring Group at Cooley Godward Kronish LLP, I wanted to let you know that we have just launched a new quarterly newsletter called Absolute Priority. The newsletter give updates on current developments in bankruptcies and workouts with the goal of keeping you "ahead of the curve" on these issues. You can access a copy of the first edition here and can register to receive future editions.

The inaugural edition is focused on the first year of experience under the October 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (known as BAPCPA). It includes articles on:

A two-page chart on M&A transactions involving Chapter 11 cases and an update on some of the bankruptcy and workout matters we have handled recently are also included. The newsletter starts with a welcome from my partner, Lawrence Gottlieb, the Chair of our Bankruptcy & Restructuring Group, and a note from another of my partners, Adam Rogoff, the editor of Absolute Priority.

I hope you find Absolute Priority informative and helpful.

Recent Developments

Trade Credit Insurer Predicts 10% Increase In Corporate Insolvencies In 2007

In a report issued last month, trade credit insurer Euler Hermes predicted that corporate insolvencies in the United States will increase by 10% in 2007. You can find details about this estimate, as well as a very interesting global economic analysis, in the full Euler Hermes global macroeconomic and insolvency outlook report.  

This updated report reflects a slightly larger predicted increase in corporate bankruptcy levels from those in its report from July 2006, which I reported on in a prior post. Interestingly, while the July report predicted that corporate insolvencies would fall by 5% in the United States during 2006, this new report states that business bankruptcy filings for 2006 will end up falling by 20% over 2005 levels. 

The report anticipates a "soft landing" for the U.S. economy in 2007, despite decelerating consumer spending, a sharp downturn in construction, an unemployment rate predicted to rise to 5.8%, and a growing current account deficit. The combination of these cyclical factors and the lower level of insolvencies in 2006, however, are likely to drive Chapter 11 bankruptcy levels higher in 2007.

Business Bankruptcy Issues Recent Developments

Bankruptcy Notices: New Rule Lets Creditors Choose A Preferred Address

You’re a creditor in a bankruptcy case and a bankruptcy notice arrives on your desk setting a deadline to object to an important motion. The address on the notice is a P.O. box located a thousand miles away, one used only for customer payments and not for legal notices. As a result, the notice took a long time to be routed to you. When you look at it more closely, you realize that so much time has passed that the deadline to respond was last week and the hearing took place yesterday. The situation can be even worse if the late-arriving notice is about a deadline (also known as a "bar date") for filing a proof of claim or perhaps for responding to an objection to your claim. 

Sound familiar?

Ability To Designate An Address. Well, one of the lesser known changes made by the 2005 amendments to the Bankruptcy Code, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), permits creditors to designate a preferred address for receiving bankruptcy notices. Section 342(f) of the Bankruptcy Code, added by BAPCPA, allows creditors to use one preferred address for cases in every bankruptcy court in the country or to designate different addresses for cases in specific bankruptcy courts.

National Creditor Registration Service. To implement this new rule, a National Creditor Registration Service ("NCRS") has been created. According to its website, the NCRS is "a free service provided by the U.S. Bankruptcy Courts to give creditors options to specify a preferred U.S. mail, e-mail address, or fax number to which bankruptcy notices should be sent." Creditors can choose to receive paper notices mailed to one or more designated addresses or faxed to specific fax numbers. Creditors also have the option of receiving bankruptcy court notices via email by registering for the Electronic Bankruptcy Noticing ("EBN") system.

  • A creditor’s preferred address and delivery method will be substituted for any address used in a bankruptcy mailing matrix (the official list of addresses for its creditors that a debtor files with the bankruptcy court) within 30 days of the creditor’s registration. (Although Section 342(f) itself mentions only Chapters 7 and 13 of the Bankruptcy Code, as implemented the system is being applied to all cases, including Chapter 11 cases.)
  • When registering, it’s important to list all of the different versions of a creditor’s name, including formal corporate names, a "doing business as" name, and even common misspellings of the creditor’s name. The service’s software will attempt to match the names the creditor supplied to the one listed in the debtor’s mailing matrix. If a match cannot be made, the notice will be sent to the address listed by the debtor.
  • NCRS allows you to complete forms online or to print them and send them in. You can find the registration forms here, here, and here, but I suggest going to the NCRS registration website itself to make sure you are using the most up-to-date forms and procedure.
  • A creditor or its bankruptcy counsel can always file a request for special notice with the bankruptcy court in a particular case using a specific address for notices in that case. In that circumstance, the address listed in the case-specific notice request will be used instead of the NCRS-listed address.

Be Prepared. Regardless of which option creditors choose, they should be prepared to handle the volume of notices that may be directed to the physical or email address. If using a physical address, creditors should be sure to monitor that address regularly and be in a position to process the notices received. A dedicated P.O. box may make sense in some cases. If an email address is used, it may be helpful to use a special email address or account for notices, create email rules to direct notices to the right person, or use other software to monitor and process those notices. With good procedures in place, the NCRS and EBN services should help creditors receive important bankruptcy notices in time to protect their rights.

What If Something Goes Wrong? Another new provision, Section 342(g), governs the situation in which notice does not get to the right address. Although courts have not yet answered how it applies in various contexts, the section provides that a notice is not "effective notice" unless it’s sent in compliance with the Bankruptcy Code’s notice rules or it’s actually brought to the creditor’s attention.

  • This section allows a creditor to designate "a person or an organizational subdivision" to be responsible for receiving bankruptcy notices. If the creditor also establishes "reasonable procedures" so that notices are delivered to the designated person or subdivision, a notice sent to the creditor other than in accordance with Section 342’s procedures "shall not be considered to have been brought to the attention of such creditor until such notice is received by such person or such subdivision."
  • In addition, a creditor that did not receive a notice of the bankruptcy filing complying with Section 342’s provisions may have a defense to a claim that it violated the automatic stay.
  • While helpful to creditors, these provisions raise questions about how debtors and trustees can be sure to send out effective notice, especially if they are not aware of which person or subdivision a particular creditor has designated for notice. That problem will be reduced if many creditors register with the NCRS or EBN system.

Get Advice. As always, if you have questions about these procedures or how they may affect you as a debtor or creditor, be sure to get advice from your bankruptcy counsel.

Business Bankruptcy Issues The Financially Troubled Company

20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy

In a recent post about a vendor’s reclamation rights, I discussed how the 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), extended a vendor’s right to reclaim goods once a bankruptcy petition has been filed. This post focuses on another of BAPCPA’s important changes affecting vendors, specifically, the new provision giving vendors an administrative claim for certain pre-petition goods sold.

Expanded Reclamation Right. As mentioned in my earlier post, a new 45 day bankruptcy reclamation right was added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the Uniform Commercial Code’s 10-day reclamation period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing. However, in some cases a vendor may not be able to reclaim its goods. The reasons can include a failure to make a timely reclamation demand, the existence of a secured lender with a lien on the goods in question, or the debtor’s prior sale of the goods. 

A Brand New Administrative Claim For Vendors, Even If Reclamation Fails. If a vendor’s reclamation claim fails, another new Bankruptcy Code section, Section 503(b)(9), gives vendors an important additional right: an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

In most cases, administrative claims are paid in full instead of only cents on the dollar as with general unsecured claims. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing.

  • Section 546(c)(2) of the Bankruptcy Code expressly provides that even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim, the vendor may still assert this special Section 503(b)(9) administrative claim. 
  • This administrative claim applies in all types of bankruptcy cases, including Chapter 11 reorganization cases, Chapter 7 liquidation cases, and Chapter 13 cases.
  • Vendors who sold goods during the 21 to 45 day period before the bankruptcy filing will have to rely on reclamation alone as to those goods.
  • In either case, vendors and debtors should keep good records of shipments and deliveries of all goods received during the 45 days before the bankruptcy filing.

Unresolved Issues. This provision has been in effect for only a year and there are still a number of unanswered questions about how it will actually work in bankruptcy cases. Reviewing these questions may give you a sense of some of the issues to keep in mind when considering whether you (if you’re a vendor) or your vendors (if you’re a debtor) will have an administrative claim for "20 day goods." These issues include:

  • Since the vendor is entitled to an administrative claim for the "value of any goods received by the debtor," does that mean the invoice price or some other amount?
  • Does the term "goods" include services bundled with the goods?
  • Does the term "goods" include intellectual property-based products, such as boxed software or other similar items, which the debtor resells or sublicenses?
  • Does the "received by the debtor" requirement exclude goods that have been drop-shipped to a debtor’s customer at the debtor’s direction?
  • What does the requirement that the goods have been "sold to the debtor in the ordinary course of such debtor’s business" really mean?
  • Does the vendor have to file a pleading to be paid on this administrative claim, given that this new section requires "notice and a hearing"?
  • Can the debtor pay for the goods at the beginning of the case, much as it would for goods purchased after the bankruptcy filing, as a way of treating qualifying vendors as "critical vendors"?
  • Can the debtor wait to pay for these "20 day goods" until a plan of reorganization goes effective, as it can for certain other administrative claims?
  • If a Chapter 11 case converts to a Chapter 7 case, will this "20 day goods" administrative claim be treated as a Chapter 7 administrative claim, ahead of all unpaid Chapter 11 administrative claims, including those for goods sold during the Chapter 11 case?
  • Will the existence of this administrative claim provision give vendors who actually got paid before the bankruptcy for "20 day goods" a new defense to a claim that the payment was preferential? 

Get Good Advice. These issues, and the potential for a valuable administrative claim, are yet another reason for vendors to get good legal advice as soon as they learn of a bankruptcy filing. Debtors also need to get good advice, both legal and financial, so they can factor in how the requirement to pay for these pre-petition goods as an administrative claim will impact their cash needs.

Stay Tuned. This provision has been in effect for only one year, and applies only to cases filed after BAPCPA took effect on October 17, 2005. No formal court decisions have addressed, much less answered, these open questions. I expect bankruptcy courts will start to answer some of these questions in the coming months, and I’ll keep you updated on those developments. 

Recent Developments

Two Search Tools For Finding Topics On Legal Blogs

I wanted to let you know about two resources that you may find helpful when trying to locate posts on legal blogs (called blawgs by some), including business bankruptcy topics. 

On the legal blog front, Justia, a company that helps legal and other bloggers design and maintain blogs, has a new service known as Justia Blawg Search. It’s both a search engine and a law blog directory, and you may find it useful if you are looking for articles and other posts by legal bloggers. 

Google also has a special search tool called Google’s Blog Search. Although still in beta, it’s focused on blogs of all kinds, including legal blogs. This tool can be particularly helpful if you want Google search results limited just to blogs. Of course, the main Google search engine includes blogs in its search results when relevant.