United States: Second Lien Financings - Answers to the Most Frequently Asked Questions

By Kirk Davenport and Marc Hanrahan in Latham & Watkin's New York office and Neil Cummings and Peter M. Gilhuly in Latham & Watkins Los Angeles office.

The purpose of this article is to answer some of the most frequently asked questions about second lien financings. These financings have become increasingly popular over the last year or so, and we think they offer a financing alternative that will remain on the menu for years to come. There is a distinct lack of agreement in the market regarding some of the critical issues that bankers and lawyers structuring these deals must address, and so we will not always offer a single answer for each of the questions we pose. However, there is also a growing consensus among the members of the finance community on many of these questions and we are pleased to report on that consensus as we see it.

Perhaps the best place to start the dialogue is with the question "What is a second lien financing?" The answer to that simple question is surprisingly complex. Some second lien deals are secured mezzanine financings with equity kickers. Others involve seller paper issued in acquisitions to the former owners of the acquired business or notes issued to the borrower’s equity owners. Still others involve asset-based lenders secured by a first lien on current assets and a second lien on property, plant and equipment sharing the balance sheet with high yield bonds secured by a first lien on property, plant and equipment and a second lien on current assets. The variations are endless. In this article, we focus on the two most common forms of this new product which are being sold in the capital markets—second lien term loans designed for sale in the institutional loan market and second lien high yield bonds. As we discuss below, there are many similarities between these two products. However, there are also a number of important differences.

At the end of this article, we have included a chart summarizing the key issues to address in structuring a second lien financing. The chart indicates how those issues are currently being resolved in the debt markets.

A typical second lien term loan is a "term loan B"¹ secured by a lien on substantially all of the borrower’s assets. In some cases, the term loan B will be secured equally and ratably with a pari passu tranche of secured bonds. Alternatively, the term loan B might be the only second lien debt in the capital structure. In either event, the term loan B lenders will almost certainly be sharing the capital structure with at least one other credit facility of the more traditional variety—possibly just a revolver or possibly a term loan and revolver—secured by a first lien on substantially the same collateral. The second lien term loan is denominated "second" because the two classes of creditors agree that, in the event any of their shared collateral is ever sold in a foreclosure or other enforcement action, either before or during a bankruptcy proceeding, the "first lien" credit facility (and all other "first lien" obligations, if any, that are then outstanding) will be entitled to be paid in full before any of the proceeds from the shared collateral sale will be distributed to the "second lien" term loan lenders. The second lien term loan is not contractually subordinated in the traditional sense (i.e., payment subordination), but it is subordinated in its claim to the proceeds of the shared collateral.

In its simplest form, a second lien bond deal is much the same as a second lien term loan—it involves a bond deal secured by substantially all of the issuer’s assets where the bondholders have agreed with the holders of "first lien" debt that they will be second in line as to distributions of proceeds from sales of shared collateral. As in the case of second lien term loans, the typical second lien bond deal is not contractually subordinated in the traditional sense. The bonds are only second in line with respect to the proceeds from sales of shared collateral. These bonds are usually called "senior secured notes" or "second lien senior secured notes" or some similar variation on that theme.

A borrower should get better pricing on a second lien financing than it would by incurring unsecured debt on substantially the same terms. In addition, a borrower will get broader access to the debt markets because of the tremendous interest in second lien paper across a range of institutional investors, including financial institutions, insurance companies, mutual funds, CBO, CDO and CLO funds and hedge funds.² For some companies, this deeper level of market interest can make the difference between being able to do a deal and not having access to the capital markets at all. Some borrowers may also perceive holders of second lien debt to be potentially less "volatile" in a distress scenario than unsecured creditors to the extent those holders believe they are sufficiently secured to successfully ride out a period of poor financial performance.

However, there are costs to the borrower associated with providing collateral to the holders of its junior debt. First, as part of the deal structure, the second lien covenant package will likely impose a more restrictive cap on the amount of additional first lien debt that may be incurred in the future than would appear in an unsecured high yield bond indenture. In addition, depending on the value of the collateral and the cash flow of the enterprise, the borrower’s ability to obtain first lien financing in the future may be impaired by the presence of a significant tranche of second lien secured debt on its balance sheet. Further, the total amount of additional second lien debt that may be incurred in the future will also be capped, usually based on a maximum leverage ratio or other financial test. Finally, it may be harder for the borrower to tap the unsecured debt market in the future because future unsecured creditors of the borrower would be effectively subordinated to all of the second lien debt.

In general, first lien lenders do not favor providing collateral to junior creditors. However, in some cases the proceeds from the second lien deal are needed to make a transaction feasible or are earmarked to pay down first lien debt or will effectively limit the amount of first lien debt needed going forward. With a lower level of credit exposure, the first lien lenders may become significantly more flexible and the increased "cushion" provided by the second lien debt may make the remaining first lien debt easier to syndicate. In addition, the first lien creditors can protect their interests through a lien subordination agreement that strips the second lien creditors of most of the secured creditor rights they might otherwise exercise to the detriment of the first lien creditors. This leaves the second lien creditors with a "silent second" lien.

Even a "silent second" gives a second lien creditor effective priority over trade creditors and other unsecured creditors, up to the value of its interest in the collateral. In terms of payment priority, "silent second" status does not affect the value of being secured—a second lien creditor is always better off in this regard than it would be if it were unsecured. In addition, under the lien subordination agreement in most deals, the second lien creditors expressly reserve all of the rights of an unsecured creditor, subject to some important exceptions.

So far, we have established that second lien debt holders get paid second when it comes to proceeds of collateral. We have also said that second liens are, at least typically, "silent seconds." So where’s the controversy? Well, the key question is "How silent is silent?" Some market participants are from the old school of senior lending. These players believe that second lien debt holders should only speak when they are spoken to. Others would characterize "silent second" lien financings as "quiet seconds." These players are willing to defer to first lien holders up to a point or for a limited period of time, but no more. All the action in the structuring and negotiating of second lien deals revolves around the determination of how silent is "silent." In order to address that critical question, we need to explore some background information about what it means to be a secured creditor in the first place. We will then discuss which of these rights second lien bondholders and second lien lenders may be willing to part with.

Basics. In traditional contractual subordination, the debt claim itself is subordinated. If a subordinated debt holder obtains anything of value in a bankruptcy from any source, it agrees to turn it over to the holders of "senior debt" until the senior debt is paid in full. In lien subordination, the liens are subordinated; the underlying debt claim is not. What this means is that the holder of second lien debt only agrees to turn over proceeds from sales of shared collateral to the holders of first lien debt. The holder of a second lien secured claim does not have to turn over funds to the holders of first lien debt distributed to it from other sources.

Priority vis-à-vis the trade. In its simplest terms, debt subordination places the subordinated debt behind the senior debt, but does not place it ahead of any other debt of the borrower (unless holders of that other debt agree, in turn, to subordinate their debt to the subordinated debt). By contrast, although lien subordination does place the second lien debt behind the first lien debt to the extent of the value of the first lien creditor’s interest in the collateral, it also places the second lien debt ahead of the trade and other unsecured creditors, to the extent of the value of its interest in the collateral. This is the key benefit for the second lien creditors.

Anti-layering covenant issues. A typical "anti-layering" covenant³ will prohibit an issuer from incurring new debt that is subordinated "in right of payment" unless that new debt is also subordinated to (or pari passu with) the debt containing the anti-layering provision. However, a typical anti-layering covenant does not restrict the incurrence of second lien debt because it isn’t subordinated "in right of payment."⁴

Payment blockage issues. Unlike traditional subordinated debt, second lien debt is not typically subject to payment blockage provisions of any kind.

Remedy standstill provisions. The remedy bars in second lien deals typically only apply to remedies associated with the collateral. Most second lien deals specifically preserve all or almost all of the remedies that would be available to an unsecured creditor, with a few exceptions (as we will discuss below). In the case of bond deals issued in public offerings (or in private placements with registration rights), the Trust Indenture Act prohibits any bar on actions to collect payments due and owing to bondholders, but it does allow limits on enforcement actions against collateral.

In a bankruptcy proceeding, secured creditors have a variety of meaningful rights that unsecured creditors don’t have. As a result, secured creditors enjoy significantly higher recovery rates in bankruptcies and other reorganizations than unsecured creditors.

Priority vis-à-vis the trade and other unsecured creditors. Under the bankruptcy code, creditors’ claims can generally be divided into three basic classes: (1) secured claims, (2) priority unsecured claims, and (3) general unsecured claims.⁵ A second lien creditor’s claim is treated as a secured claim to the extent of the value of its interest in the collateral. For example, assume the company in bankruptcy owes $50 to a first lien creditor and $200 to a second lien creditor and that both the first and second lien debt are secured solely by liens on an asset worth $150. In this case, the first lien creditor will have a $50 secured claim and no unsecured claim. The second lien creditor, in turn, will have a secured claim of $100. The second lien creditor’s residual $100 claim will be treated as a general unsecured claim. As a result, an "undersecured" creditor will hold both secured and unsecured claims. Under the bankruptcy code, secured claims are entitled to receive value equal to the full value of their interest in the collateral before any value is given to holders of unsecured claims, and any priority unsecured claims are entitled to receive the full value of their claims before any general unsecured claims receive any value. To the extent a secured creditor is "undersecured" (i.e., the value of its collateral is less than the amount of its pre-petition claim) that undersecured creditor will share pro rata with other general unsecured creditors (including trade creditors) in the amount, if any, remaining after repayment in full of both secured claims and priority unsecured claims.

Post-petition interest. A secured creditor is entitled to post-petition interest under the bankruptcy code to the extent the value of its interest in the collateral securing its claim is greater than the amount of its pre-bankruptcy claim. An undersecured creditor is not entitled to post-petition interest. As a result, in the example discussed above, the first lien creditor’s $50 secured claim will increase during the pendency of the bankruptcy proceeding to the extent of any accrued interest that is not paid currently, thereby reducing the likely recovery by the second lien creditor.

Adequate protection rights. Under the bankruptcy code, a secured creditor has the right to be protected against declines in the value of its interest in the collateral following the date of the bankruptcy filing. This is a very broad right and entitles a secured creditor to a voice in any actions taken in a bankruptcy proceeding that could affect the value of its collateral (including the use of cash collateral, sales of collateral, substitutions of collateral or the grant of a priming lien on collateral to secure a DIP financing). Upon request, secured creditors are entitled to assurance that their collateral is adequately protected if there is a serious risk of its diminution in value. The "adequate protection" may take the form of a court-ordered grant of additional or substitute collateral or the provision of periodic cash payments to the secured creditor. The bankruptcy court has broad discretion in fashioning an appropriate remedy in this regard.

Right to object to use of cash collateral. "Cash collateral" is a defined term in the bankruptcy code and includes cash, negotiable instruments, securities, deposit accounts and other cash equivalents in which a pre-petition creditor has a security interest. Under the bankruptcy code, a company in bankruptcy is not permitted to use cash collateral unless each creditor that has a security interest in the cash collateral consents to its use or the bankruptcy court authorizes its use, after notice and a hearing. This gives each secured creditor a say on the use of cash collateral, unless the bankruptcy court orders otherwise.

Right to approve asset sales. Under the bankruptcy code, a company in bankruptcy can sell assets, free and clear of all liens, in various circumstances. However, under certain circumstances, the consent of a secured creditor to a sale of its collateral may be required. If more than one party has a lien on the collateral, each of the secured creditors may be required to consent to the sale.

Right to approve secured DIP financings. A company in bankruptcy needs funds to operate. For obvious reasons, many bankrupt companies have negative or marginal cash flow, which prompts the need for "debtor-in-possession" or "DIP" financing arrangements. DIP financings can be secured or unsecured, but are generally secured on a first priority basis. The bankruptcy code authorizes the bankruptcy court to provide for a DIP loan to be secured by a lien that is senior or equal to the liens held by the other secured creditors, as long as those other secured creditors are given adequate protection or consent to the prior or equal liens. As a result, creditors secured by all or substantially all of the bankrupt company’s assets will have a strong say over the company’s ability to obtain a priming DIP loan.

Harder to be "crammed down." In a bankruptcy, the creditors in each class have the right to vote on any proposed plan of reorganization. However, in certain circumstances, a plan of reorganization can be confirmed over the objections of a particular class of creditors. A class of creditors that is forced to accept the terms of a plan that it voted against is said to be "crammed down." It is generally much harder for a class of secured creditors to be "crammed down" in a bankruptcy than a class of unsecured creditors. Under the bankruptcy code, a class of creditors can only be crammed if the plan of reorganization is "fair and equitable" to that class. The standard for what is fair and equitable is higher for secured creditors than it is for unsecured creditors, which gives secured creditors greater leverage at the bargaining table in bankruptcy plan negotiations.

More leverage in plan negotiations. The combined effect of these various secured creditor rights is to give secured creditors far more leverage than unsecured creditors in negotiating and shaping the plan of reorganization.

Unsecured creditors (as well as secured creditors) have several important rights outside of bankruptcy, including:

• the right of any three unsecured or undersecured creditors to put a company into an involuntary bankruptcy;⁶
• the right to accelerate their debt and sue for payment; and
• the right to challenge the validity, enforceability or priority of any liens on the company’s assets.

As a result, unsecured creditors need to be reckoned with and will be "at the table" in any out-of-court restructuring process if they are not being paid current interest.

Unsecured creditors (as well as secured creditors) have other meaningful rights during a bankruptcy, including:

• to request the appointment of a trustee in bankruptcy (e.g., because the bankrupt company is mismanaging the business);
• to propose a plan of reorganization at the end of the 180-day (or longer) time-period in which the bankrupt company has the exclusive right to propose a plan;
• to vote on a plan of reorganization;
• to challenge the validity, enforceability or priority of any liens on the bankrupt company’s assets; and
• to challenge or dispute any other actions taken or not taken, or any motions made, by the bankrupt company, any secured creditor or any other interested party.

Although, generally, the rights of an unsecured creditor in bankruptcy are significantly less than those of a secured creditor, they are enough to give unsecured creditors a "seat at the table" in the plan negotiations.

Order of priority. The general rule is first-in-time, first-in-line. Under that general rule, as between two secured creditors, unless otherwise agreed by those creditors, the first to "perfect" its security interest in an asset gets the first priority lien on that asset. The second in time is second in line.⁷ Priority is important because it determines the order of repayment when the collateral is sold or otherwise disposed of.

Control over enforcement actions. If two creditors are secured by liens on a particular asset, the general rule under the Uniform Commercial Code, or UCC, and other applicable laws is that either creditor has the right to foreclose on the asset. If the first lien creditor forecloses on the asset, the second lien creditor is not entitled to any of the foreclosure proceeds until the first lien creditor has received the full value of its claim. If the second lien creditor forecloses on the asset, the first lien remains in place on the sold asset and the second lien creditor is entitled to the foreclosure proceeds. However, as a practical matter, few buyers in a foreclosure sale are willing to buy an asset subject to a first lien, and few first lien creditors are willing to release their first liens unless their debt has been repaid in full. As a result, it is common for the agreements between creditors to provide that the first lien creditors have the right to control the disposition of collateral (possibly subject to time or other limitations).

Restrictions on dispositions of collateral. A secured creditor does not have an unfettered right to dispose of collateral. The interests of the debtor and other secured creditors are protected by a variety of rules designed to protect the interests of the debtor and other secured creditors in the value of the collateral, if any, remaining after repayment in full of the claims of the secured creditor that forecloses on the collateral. Most of these rules can’t be waived by a debtor or other pledgor or may only be waived by a debtor or other pledgor under an agreement entered into after a default has occurred. In addition, in certain cases, particularly where the first lien creditor has agreed to serve as agent for the second lien creditor, a first lien creditor may owe fiduciary duties⁸ to the second lien creditor. These rules effectively limit the ability of a secured creditor to conduct collateral "fire sales."

Rules governing foreclosure on UCC collateral. The UCC contains a variety of substantive and procedural requirements governing foreclosure on personal property collateral that is subject to the UCC.⁹ Most important, under the UCC, every aspect of a disposition of collateral must be "commercially reasonable." A secured party is liable to the debtor and other parties with a security interest in the same collateral if it fails to comply with this standard or if it fails to comply with any of the notice or other requirements surrounding foreclosure imposed by the UCC. These UCC requirements also effectively limit the ability of any secured creditor to sell collateral at a "fire sale."

Rules governing foreclosure on real property collateral. The substantive and procedural requirements that govern foreclosure of real property collateral vary from state to state. In most states, a secured creditor can foreclose on real property through a judicial foreclosure, supervised by a state court. In some states, a secured creditor can also enforce remedies against real property outside of the court system through a non-judicial foreclosure in which a trustee or referee conducts the sale. If the sale is conducted through a judicial foreclosure, the secured party will typically have to satisfy procedural requirements intended to ensure that the sale is conducted in a public forum to protect against a sale of the real property below fair market value.

Fiduciary duties in the "zone of insolvency." Directors and officers of a company owe a fiduciary duty to the company’s shareholders to act in what they reasonably believe to be the best interests of the shareholders. However, if the company enters the "zone of insolvency," those fiduciary duties are additionally, and primarily, owed to the company’s secured and unsecured creditors. A company in bankruptcy clearly falls within the zone of insolvency. However, a company can also be in the zone of insolvency as it approaches bankruptcy. As a rule of thumb, a company is in the zone of insolvency if it can’t generally pay its debts as they become due or if the fair market value of its assets is less than the fair market value of its liabilities. These fiduciary duties to creditors are a further limit on the likelihood that collateral will be disposed of in haste at significantly below its fair market value.

Bankruptcy code restrictions. The bankruptcy code also imposes its own set of restrictions on asset sales. During a bankruptcy, with limited exceptions, a secured creditor generally does not have a right to compel sales of collateral. As a general matter, the company in bankruptcy decides which assets to sell (albeit, in practice, following discussions with its secured creditors). Asset sales are governed by Section 363 of the bankruptcy code. These "363 sales," as they are commonly known, are subject to overbidding and bankruptcy court scrutiny and approval, with a view to achieving the best available sale price.

With that background discussion behind us, we will now turn to a series of specific questions about how to structure a second lien financing.

A lien only becomes "silent" if the holder of the lien agrees not to exercise some or all of the special rights that it obtained by becoming a secured creditor. The terms of the "silent second" are usually set out in an agreement entered into by the representatives of the various classes of creditors (typically a collateral trust agreement or an intercreditor agreement). Second lien bond deals tend to be more "silent" than second lien term loan deals. However, customary "silent second" lien subordination agreements in both the bond and term loan markets have four primary elements:

• prohibitions (or limitations) on the right of the second lien holders to take enforcement actions, with respect to their liens (possibly subject to time or other limitations);
• agreements by the holders of second liens not to challenge enforcement or foreclosure actions taken by the holders of the first liens (possibly subject to time or other limitations);
• prohibitions on the right of the second lien holders to challenge the validity or priority of the first liens; and
• waivers of (or limitations on) other secured creditor rights by the holders of second liens.

The answer to this question depends on the context. In a second lien bond deal, the second lien creditors tend to be truly "silent." This means that the first lien lenders generally control all decisions regarding the enforcement of remedies against the collateral as long as any first lien debt is outstanding. As a result, following a default on the first lien debt, subject to the UCC, bankruptcy code and other legal limitations discussed above, the first lien lenders typically decide, among other things: whether and when to exercise remedies against the collateral;

• which items of collateral to proceed against and in which order;
• whether the sale should be a public or a private sale; and
• to whom collateral should be sold and at what price.

However, the answer to this question can change dramatically if the total amount of the second lien bond debt significantly exceeds the amount of the first lien debt. If there is significantly more second lien bond debt in the capital structure than first lien bank debt, the bonds may expect to have an active (and possibly even controlling) voice in the exercise of remedies under the security agreements.

By contrast, in a second lien term loan deal, the second lien is often more in the nature of a "quiet second." Generally, second lien lenders will only agree to refrain from exercising their secured creditor rights for a limited period of time, typically 90 to 180 days. This period of time is often referred to as a "fish-or-cut-bait" or "standstill" period. At the end of the standstill period, the first lien lenders lose their monopoly on the exercise of secured creditor remedies. In a small number of deals, if the first lien lenders have not taken steps to exercise remedies against the collateral when the standstill period expires, they forfeit any further right to take remedies, giving the second lien lenders the monopoly on remedies. There are many variations on the scope and duration of these temporary standstill arrangements.

Both second lien term lenders and second lien bondholders typically waive their right to challenge the validity, enforceability or priority of the first liens.¹⁰

The short answer is all of the same rights they waive before bankruptcy (see above), plus some others. The longer answer depends, again, on the context. The post-bankruptcy waivers tend to be broader in second lien bond deals than in second lien term loan deals. We think this will likely continue to be the case as investors in the term loan market tend to have a stronger desire to participate in plan negotiations than buyers of bonds in Rule 144A financings. Bond buyers are typically more focused on getting priority over trade creditors than on retaining any particular rights in a bankruptcy case. The following waivers and consents are commonly seen in lien subordination agreements in both the bond and term loan markets:

• adequate protection waivers;
• advance consents to use of cash collateral;
• advance consents to sales of collateral; and
• advance consents to DIP financings.

Waiver of the right to seek "adequate protection." First, let’s look at the bond market. It is currently typical for second lien bondholders to waive their right to claim adequate protection on their own behalf until the first lien debt has been paid off, with some limitations. However, second lien bondholders will typically (and should) reserve their adequate protection rights to ask for a junior lien on any property on which the bankruptcy court grants a lien to secure first lien debt, as long as the new junior lien is subject to the same lien subordination arrangements as the original second lien. This right is critical to avoid erosion of the second lien bondholders’ bargained—for collateral. Most security agreements contain an "after-acquired collateral" clause that grants the secured creditor a lien on all then-owned collateral and on any collateral acquired in the future. However, under the bankruptcy code, liens created prior to a bankruptcy generally do not attach, or apply, to assets acquired or arising after the commencement of the bankruptcy proceeding. As a result, it is customary for secured creditors to agree to permit uses of the cash proceeds from sales of their collateral consisting of inventory, accounts or other similar classes of "quick assets" only if the court permits them to obtain a lien on "quick assets" created or acquired after the commencement of the bankruptcy. In general, the first lien lenders can be counted on to make this request (typically phrased as an adequate protection motion). However, the second lien creditors need to be able to tag along in order to preserve their second liens on "quick assets" acquired after the commencement of the bankruptcy or they will lose the benefit of their bargain.

The market is less settled for second lien term loans. In some cases, particularly where there are second lien term loans and pari passu second lien bonds with similar (or even identical) covenants, the term loans will waive their adequate protection rights for so long as any first lien debt is outstanding in the same way that the pari passu bonds waive these rights. However, in many cases, there is strong resistance by some participants in the institutional term loan market to agree to any adequate protection waivers. It is unclear at this point where the second lien loan market will settle on this important issue.

The practical significance of these adequate protection waivers depends on the facts of the case. Excluding the ability to have a say in the use of cash collateral and DIP financings (which we will discuss below), the principal benefit of adequate protection is the right of a secured creditor to ask for additional or substitute collateral to protect against declines in the value of the collateral after the date on which the bankruptcy commenced. This right is of critical importance to a holder of liens on "quick assets" (as discussed above), and it is also meaningful if the company in bankruptcy has valuable unencumbered, or partially encumbered, assets on which additional or replacement liens can be granted to protect the value of the original liens. The remedy is of more limited utility to a second lien creditor that already has a lien on all of the borrower’s assets.

In most cases, the borrower will have some unencumbered assets and the grant of a lien on those assets to compensate for deterioration in the value of the second lienholder’s original collateral may materially enhance the second lien creditors’ ultimate recovery. The value of the second lien creditors’ interest in any additional or substitute collateral obtained to secure second lien obligations increases, dollar for dollar, the amount of the secured claims held by the second lien creditors. As a result, giving up the opportunity to obtain additional or substitute collateral in the name of adequate protection could have real-world cost. On balance, however, if the second lien creditors preserve their right to obtain a second lien on any new collateral provided to the first lien creditors in the name of adequate protection, their waiver of the right to seek other forms of adequate protection on their own will not prove to be an imprudent concession in most real-world circumstances.

Waiver of the right to oppose "adequate protection" for the first lien debt. Both second lien term lenders and second lien bondholders typically waive any right to dispute actions taken by the first lien lenders to seek adequate protection with respect to the collateral securing the first lien debt. This waiver is not particularly controversial and is not usually subject to any time limitation.

Advance consent to the use of cash collateral. Both second lien term lenders and second lien bondholders typically give an advance consent to any use of cash collateral approved by the first lien debt (effectively waiving their right to oppose the company’s proposed use of cash collateral on adequate protection grounds). The primary benefit to a secured creditor of an approval right over the use of cash collateral is that it allows the secured creditor to put a brake on the company’s activities (and thereby force a liquidation), since a company in bankruptcy invariably cannot operate without access to cash and other cash collateral. Secured creditors can, and frequently do, condition access to these funds on adoption by the company in bankruptcy of a satisfactory operating budget. As a result of this advance consent, the second lien debt will almost certainly be required to rely on the first lien creditors to handle these budget negotiations.¹¹

Advance consent to sales of collateral. Both second lien term lenders and second lien bondholders typically agree not to object to any court-approved asset sale that is also approved by the first lien lenders as long as the second liens attach to the proceeds of the sale in accordance with the lien priorities agreed to in the lien subordination agreement. Second lien term lenders (but generally not second lien bondholders) may additionally condition their advance consent on the use of all or a specified portion of the sale proceeds to permanently reduce the first lien debt. By providing an advance consent to asset sales, the second lien debt no longer has any say as to sales of collateral approved by the first lien debt. If the second lien debt is undersecured, it may be relying on a successful reorganization of the debtor for repayment of its debt. The first lien debt, on the other hand, is much more likely to be oversecured and will often want a quick liquidation of the bankrupt company’s assets, without regard to the company’s prospects of emerging from bankruptcy. This opens the door to the possibility for mischief, such as a fire sale of assets at below fair market value or a sale of key income-generating assets or other material assets whose sale might eliminate the possibility of a successful reorganization. However, there are other protections for the second lien creditors—the sale still has to be approved by the bankruptcy court and must be conducted through an auction process, at which the second lien creditors can bid,¹² and the fiduciary duties and other legal requirements discussed above should prevent most of the potential for mischief from ever coming to fruition.

Advance consent to DIP financing approved by the first lien debt. Second lien term lenders and second lien bondholders typically agree to some form of advance consent to DIP financings. This advance consent appears in various permutations:

• unconditional consent to any DIP financing approved by the first lien creditors, with no cap on the amount of the DIP financing;
• conditional consent to any DIP financing approved by the first lien creditors, subject to a dollar cap (which typically includes a cushion to allow "protective advances") on the amount of the DIP financing; and
• conditional consent to any DIP financing approved by the first lien creditors, but only if the liens securing the DIP financing rank prior or equal to the liens securing the first lien debt.

The third permutation is becoming increasingly popular. It is attractive to second lien creditors because it requires the first lien creditors to "share the pain" and thereby reduces the chances of an overly-generous DIP, and it is acceptable to first lien creditors and borrowers because it does not arbitrarily cap the amount of the DIP financing. This permutation is generally a reasonable and fair compromise from the perspective of all parties involved.

Some deals reflect the lien subordination terms in a collateral trust agreement, while others use an intercreditor agreement. Substantively, the choice of document is a distinction without a difference—it doesn’t affect the terms of the subordination agreements themselves. Typically, the parties will use a collateral trust agreement if an independent collateral trustee holds the first and second liens for the benefit of both the first and second lien debt. Most of the larger second lien bond deals have employed an independent collateral trustee. Conversely, where the parties prefer to have separate entities hold the first and second liens, the subordination provisions are usually documented in an intercreditor agreement. This latter method is more common in the term loan market.

Courts are generally willing to enforce lien subordination agreements between a company’s creditors, even where the company is in bankruptcy. The bankruptcy code specifically says that a subordination agreement is as enforceable in a bankruptcy as it is outside of bankruptcy. As a general matter, a lien subordination agreement containing the types of provisions discussed above should be enforceable under state law, both before and during a bankruptcy. In practice, most bankruptcy courts will not monitor compliance with every aspect of the advance waivers and consents contained in a lien subordination agreement, but the final plan of reorganization will likely give effect to the agreement’s priority waterfall provisions by treating first and second lien creditors as separate classes for plan purposes.¹³ As a court of equity, a bankruptcy court may well allow the second lien creditors to assert rights they agreed to waive in the lien subordination agreement, leaving the first lien creditors to sue the second lien creditors in state court for breach of contract damages. In practice, that course will not likely be appealing to the first lien creditors absent repeated and flagrant disregard of the original bargain by the second lien creditors.

Typically, a lien subordination agreement expressly states that, both before and during a bankruptcy, the second lien creditors can take any actions and exercise any rights that they would have had if they were unsecured creditors, except any rights they expressly waived in the lien subordination agreement, such as with respect to adequate protection, use of cash collateral, sales of collateral, DIP financings and the right to challenge the first liens.¹⁴ We think these limitations are appropriate. We have seen first lien creditors go even further, however, and request advance agreements by the second lien bondholders on how they will vote on a plan of reorganization. These voting agreements generally come in two basic forms: (1) an agreement not to support or vote in favor of a plan, unless the first lien creditors vote in favor of the plan or the plan meets certain conditions (e.g., that the first lien debt gets repaid in full), and (2) an agreement not to oppose a plan supported by the first lien creditors. These voting agreements are more controversial and may not be enforceable.

The right to vote on a plan of reorganization provides significant protections for a secured creditor. First and second lien creditors have very different interests and they frequently (and often strongly) disagree on the merits of a proposed plan. Furthermore, unsecured creditors almost never agree to limit their voting rights in a plan and including such a provision in a lien subordination agreement could cause the "silent second" lien creditor to have significantly less bargaining power than an unsecured creditor in plan negotiations. These factors may explain why restrictions on the right to vote for or against particular plans of reorganization are relatively rarely agreed to by second lien bondholders and almost never agreed to by second lien term loan lenders.

Generally, the second lien documents provide for an automatic release of the second liens on any collateral upon a sale of that collateral, possibly subject to the requirements of an agreed "asset sale" covenant.¹⁵ There is less consensus as to who controls releases of collateral outside of the sale context. In the high yield bond market, we believe there are three broad approaches to this issue:

• In some bond deals, the first lien creditors can release any or all of the collateral on behalf of both first and second lien creditors at any time.
• In other deals, releases of collateral from the second liens are only allowed if permitted under the documents governing both the first and second lien debt.
• In still other deals, the first lien creditors can release collateral on behalf of both the first and second lien creditors, unless it involves "all or substantially all" of the collateral, in which case, both the first and second lien debt must approve the release.

This last approach is the middle ground and is where we expect the second lien bond market to settle. Holders of second lien loans, on the other hand, have a different perspective, and generally won’t agree to allow the first lien debt to control the release of any of their collateral. We have generally observed second lien term loans agreeing to allow releases of their collateral by an act of the first lien creditors only in deals where the second lien term loans are pari passu with a tranche of high yield bonds being marketed concurrently that contains a similar provision.

During a bankruptcy, the market standard seems clear. The second lien holders, whether bondholders or term loan providers, typically agree not to object to any court-ordered asset sale approved by the first lien creditors as long as the second liens attach to the proceeds of the sale in accordance with the lien priorities agreed to in the lien subordination agreement.

Generally, the first lien debt will hold a "blanket lien" on all assets of the borrower and the guarantors, with very limited exceptions. The exceptions will typically involve situations where the first lien lenders conclude that the cost and effort of obtaining a particular lien outweighs the benefit of that lien to the first lien lenders, or the borrower is unable to obtain contractually-required third party consents to the grant of the first liens.¹⁶

In general, the second lien collateral will not include any assets excluded from the first lien collateral. The second lien creditors will generally expect to have a lien on all of the assets securing the first lien debt. However, depending on the type of debt making up the second lien debt, certain categories of assets may be excluded from the second lien collateral. If the second lien debt consists solely of term loans, there will tend to be very few (if any) differences between the collateral securing the first lien debt and the collateral securing the second lien term loans. However, if the second lien debt consists of or includes registered bonds or bonds sold with registration rights, there may be important differences between the first lien and second lien collateral packages for the legal and practical reasons discussed below.