second lien

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Business Bankruptcy Issues The Financially Troubled Company

Second Liens And Recharacterization: Is More Litigation Around The Corner?

In many Chapter 11 bankruptcy cases, unsecured creditors investigate whether a basis exists to recharacterize existing secured debt as equity. The reason? A successful challenge can turn first or second lien secured debt into "back-of-the-line" capital contributions, enabling unsecured creditors to realize a much greater recovery. A recent article by two of my Bankruptcy & Restructuring Group colleagues at Cooley Godward Kronish LLP, Ronald R. Sussman and Michael A. Klein, digs deeper into the complex issues behind these claims.

Appearing in the October 2008 edition of The Journal of Corporate Renewal published by the Turnaround Management Association, the article is entitled "Recharacterization Battles Likely in Next Round of Bankruptcies." You can access a copy of the article, reprinted with permission of The Journal of Corporate Renewal (© 2008, The Journal of Corporate Renewal), by clicking on its title in the prior sentence. It first discusses the concept of recharacterization itself, including the key factors courts typically apply. Next, the article compares recharacterization to the doctrine of equitable subordination under Section 510(c) of the Bankruptcy Code and examines some of the key differences between the two.

After setting the stage, the article then looks ahead to what appears to be a coming wave of bankruptcy cases. It focuses on how future efforts by unsecured creditors to challenge second lien loans — a type of financing that has become a major part of corporate capital structures over the past several years — may fare:

The next wave of bankruptcies undoubtedly will include attempts by unsecured creditors to recharacterize second lien debt as equity, especially when the second lien holder is an insider of the debtor. However, the current framework established by Bankruptcy Courts presents significant obstacles to unsecured creditors seeking to knock out the second lien claims of lenders that provided capital on a purportedly secured basis to a struggling debtor that was unable to find capital from alternative sources.

The article observes that, given the present state of the law, courts will have to embrace a more flexible legal standard if unsecured creditors are to have success in recharacterizing second lien debt as equity. It concludes by offering a different approach for addressing recharacterization with this new landscape in mind. Unsecured creditors, lenders, insolvency professionals and others confronting these issues will find the article to be a helpful and interesting read.

Business Bankruptcy Issues Recent Developments

Will Section 363 “Free And Clear” Sale Orders Survive An Appeal? A Recent Appellate Decision Raises New Doubts

The primary objective of any buyer at a Section 363 sale, whether one purchasing for cash or an existing secured creditor making a credit bid, is to obtain good title to the purchased assets free and clear of any liens, claims, or interests. However, a recent decision on this subject by the Bankruptcy Appellate Panel (“BAP”) of the United States Court of Appeals for the Ninth Circuit is causing something of a stir in the bankruptcy world.

In Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), the Ninth Circuit BAP held that a senior secured creditor’s credit bid, in an amount less than the aggregate value of all liens against the property in question, did not satisfy the requirements of Section 365(f) and permit the sale to be “free and clear” of the existing junior liens on the property and reversed the bankruptcy court’s order on appeal. You can read the entire opinion by following the link in this sentence.

For an excellent discussion of the decision and the analysis employed by the BAP, be sure to read Steve Jakubowsi’s post on the case over at The Bankruptcy Litigation Blog. Instead of covering the same ground, I want to discuss some of the implications of the decision for Section 363 bankruptcy sales.

Credit Bid Or Foreclosure? First, the Clear Channel decision raises questions about how a senior secured creditor should proceed in a bankruptcy case.

  • On the one hand, the BAP’s decision that a sale will not be “free and clear” of junior liens is not that surprising. It has generally been accepted that for a “short sale” under Section 363 (one in which the purchase price is less than the amount of liens against the property) to be free and clear of liens, the secured creditors must consent or one of the other exceptions under Section 363(f) must be satisfied. Those other exceptions include a lien subject to “bona fide” dispute or a situation in which the lien holder can be forced to accept a cash payment in satisfaction of the lien.
  • What has surprised some about this new decision is the holding that a credit bid by a senior secured creditor also cannot be made free and clear of junior liens, even though the senior secured creditor could have wiped out the junior liens through a foreclosure under state law.
  • Section 363(f)’s focus on the “aggregate value of all liens on such property” makes the existence of junior liens the issue, regardless of whether they are in the money. Put differently, even if the junior liens are worthless, they exist and a Section 363 sale to a credit bidding senior secured creditor will not be free and clear of those junior liens.
  • With the enormous increase in second lien lending over the past several years, including many second lien loans made as part of private equity buyouts, expect to see more Chapter 11 bankruptcy cases in which substantial junior liens are present.

This ruling seems to leave secured creditors seeking to take title to their collateral with two main choices. One is to seek relief from the automatic stay to foreclose on its collateral, avoiding the Section 363 sale and credit bid approach altogether. If the assets cannot be sold for cash in an amount greater than the senior secured creditor’s claim, and if a reorganization is not reasonably in prospect (the key factors in a bankruptcy court’s decision whether to lift the stay), this may be the preferred path. A second approach would be to complete the credit bid through a Chapter 11 plan of reorganization, something the Clear Channel court implied was also available. However, some secured creditors may find the delay and expense involved in being a plan proponent problematic. As a plan proponent, the secured creditor would take on the obligation to pay administrative expenses of the estate on the effective date of the reorganization plan, as well as satisfaction of all of the other requirements for confirming a plan.

The Risks Of An Appeal: The Limits Of Section 363(m) And The Mootness Doctrine. Second, perhaps the most important aspect of the Clear Channel decision is the risks it exposes even for “good faith” purchasers in Section 363 sales. Purchasers of assets under Section 363 regularly seek a finding that they are a good faith purchaser because a sale to such a buyer cannot be overturned on appeal. This protection is found in Section 363(m) and reads as follows:

The reversal or modification on appeal of an authorization under subsection (b) or (c) of this section of a sale or lease of property does not affect the validity of a sale or lease under such authorization to an entity that purchased or leased such property in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and such sale or lease were stayed pending appeal.

Here, the BAP held that although the sale itself to the senior secured creditor could not be overturned on appeal, the protection of Section 363(m) did not extend to the question of whether the sale was made “free and clear” of the junior liens. Instead, the BAP ruled that even in the absence of a stay pending appeal, the appellate court could reverse the “free and clear” determination because Section 363(m) is expressly limited to sale orders under Sections 363(b) and (c), which authorize the sale or lease of property, and does not extend to “free and clear” orders under Section 363(f).

Going hand in hand with the Section 363(m) ruling was the decision’s holding that the closing of the asset sale did not render the “free and clear” issue moot. Instead, even though no stay pending appeal was obtained, the BAP concluded that relief could still be granted on the “free and clear” question by ordering that the junior lien remained attached the property even after its sale.

When Should A Buyer Close The Sale? The Section 363(m) and mootness rulings raise issues about when a buyer of assets under Section 363 should close on the sale. The BAP’s views on Section 363(m) and mootness do not appear limited to the credit bid situation involved in the Clear Channel decision. Instead, if a good faith purchaser for cash pays less than the “aggregate value of all liens” against the purchased assets — or perhaps a question exists whether a lien or interest is really in “bona fide” dispute — the “free and clear” aspect of the sale may be outside the protection of Section 363(m) and an appeal by a secured creditor or other interest holder may not be moot.

  • Buyers usually prefer to close as soon as possible after entry of a bankruptcy court’s order approving the sale, especially if the value of the assets are declining or the debtor is running out of cash.
  • A buyer that closes with an appeal threatened runs the risk of having the “free and clear” decision overturned months or even years later and the purchased assets suddenly subject to the debtor’s liens.
  • While every sale objection or appeal will not raise these issues, if a serious objection to the “free and clear” aspect of the bankruptcy court’s sale order has been made, and the objector is likely to appeal, the buyer should consider whether to wait until the later of (a) the passage of the 10-day appeal period, or (b) a final appellate decision affirming the bankruptcy court’s denial of the objection, before agreeing to close the sale.
  • Buyers may want to consider including provisions in the asset purchase agreement to permit this type of flexibility on when to close or to terminate the agreement if the closing is substantially delayed.

The Precedential Effect Of A BAP Decision. Unlike a U.S. Court of Appeals itself, a BAP is made up of bankruptcy judges, not federal circuit judges. Given a BAP’s place in the judicial system’s hierarchy, its decisions are not given the same precedential weigh as U.S. Court of Appeals decisions, and this means that the U.S. Court of Appeals for the Ninth Circuit might reach a different conclusion. Moreover, BAP decisions generally are not binding on bankruptcy courts in the Ninth Circuit. That said, some bankruptcy judges make a practice of following BAP decisions and the BAP’s reasoning may influence other judges.

Conclusion. The BAP’s Clear Channel decision has important implications for Section 363 asset sales. Secured creditors intent on making a credit bid may now rethink that approach when junior liens are present. Cash buyers may be more cautious on when to close a sale if disputes exist over whether the sale should be “free and clear” of existing liens and interests. It will be interesting to see how other courts, in the Ninth Circuit and beyond, react to the decision, so stay tuned.

Business Bankruptcy Issues Recent Developments

Are Risk Levels Rising For The Debt That’s Financing Private Equity Deals?

The New York Times DealBook blog has an interesting post about the risks posed by all the debt that helps fund the many private equity buyouts these days. It points to two articles in the UK press on the topic.

The first article, in the Financial Times, discusses comments by Larry Fink, the CEO of BlackRock, about how increasing levels of debt, lowered risk premiums, and less restrictive lending standards in connection with today’s private equity deals may end up creating "tomorrow’s problem." A major downturn in the economy could transform buyout debt into distressed debt.

The second article, in The Guardian, reports on the Bank of England’s warning about "how quickly credit quality can deteriorate following a period of lax credit standards." Sir John Gieve, one of the Bank of England’s deputy governors, is quoted as saying that the "rapid growth in credit risk transfer markets is also making more participants dependent on continuous market liquidity and could amplify the impact of a sharp reversal in credit spreads from their current low levels."

In addition, an increasing amount of corporate debt now involves second lien loans, and out-of-court restructurings and bankruptcy cases could be noticeably more complex.  Although neither article suggests that defaults are about to spike, the perspectives offered about how quickly that could change — if economic conditions turn for the worse — makes for interesting reading. 

Business Bankruptcy Issues Recent Developments

New Article On How Distressed Debt Investors Are Preparing For The Next Economic Downturn

The DealBook blog from the New York Times has an interesting post entitled "Stocking Up For A Storm." It describes how certain investment banks have been expanding their distressed debt businesses, believing that the length of the current "good times" period may actually lead to an increase in the level of distress when the economy finally turns. 

The DealBook post points readers to a new article in The Economist on so-called vulture investors. Entitled "The Vultures Take Wing," the article discusses the view of many investors and insolvency professionals that, after a drought of restructurings, a new wave of bankruptcies and defaults may not be too far off. When the problems come, they will likely be even more complex than in past cycles. Not only have very active hedge funds taken a much greater role in recent years, but many companies now have an additional tranche of secured debt in the form of the increasingly popular second lien loans.

While corporate restructurings and Chapter 11 bankruptcy cases have always been complex, when the next surge in defaults hits these trends are likely to present even more challenges — and perhaps opportunities — for both debtors and creditors.

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.