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

There are two sets of restrictions that apply only to registered bonds or bonds that are subject to registration rights.

First, Section 3-16 of Regulation S-X under the Securities Act makes it very difficult to give bondholders a lien on stock (or intercompany notes) of subsidiaries. That section requires an annual audit of each subsidiary whose stock (or intercompany notes) is pledged if the value of the stock (or notes) exceeds 20 percent of the face amount of the secured bonds.¹⁷

Second, the Trust Indenture Act applies to debt securities issued under an indenture in a registered offering (or subsequently registered pursuant to a registration rights agreement). Section 314(d) of the Trust Indenture Act includes various certification and opinion requirements that must be satisfied prior to the release of collateral securing notes issued under a public indenture. Generally, those certifications and opinions can be made by an officer of the issuer. However, subject to limited exceptions, if the value of the collateral to be released is 10 percent or more of the amount of the notes then outstanding under the indenture, those certifications and opinions must be provided by an independent engineer, appraiser or other independent expert.

In most cases, no certificates or opinions will be required for releases of collateral in the ordinary course of business, although the SEC orders granting the ordinary course exemptions are not as sweeping as might be expected. Another way out of the Section 314(d) requirements is to give the first lien creditors control over the "on/off" switch for both the first and second liens. In an exemptive order granted by the SEC in 2001, the SEC determined that the Section 314(d) requirements do not apply at all if a third party (such as another group of secured creditors) controls the release of the collateral.¹⁸ This latter approach is favored by issuers who do not want the administrative burden of producing independent engineer’s opinions under any circumstances and seems a fair resolution of the debate on who controls lien releases as long as less than all or substantially all of the collateral is involved. The state of the current law is less than entirely clear, however, and we think the SEC should make clear that the burdensome requirements of Section 314(d) are not intended to apply to any releases of collateral provided for in the original indenture.

If the borrower persuades the first lien debt at a future date to release part of its collateral (because the credit has improved or for some other reason), the first lien debt will almost certainly condition its lien release on the second lien debt not having a lien on the collateral to be released. In a deal where the first lien creditors do not have authority to release liens on behalf of both first and second lienholders, the borrower will want to avoid the need for a second lien bondholder consent (which may involve an expensive and cumbersome consent solicitation) every time it wants collateral released. As a result, second lien bondholders have often been persuaded to accept a more limited collateral package than the first lienholders. In particular, it is not uncommon for bondholders to forego liens on immaterial parcels of owned and/or leased real property and to provide for a general exclusion for personal property in which a security interest can’t be perfected by the filing of a UCC financing statement (up to some agreed cap).¹⁹ This general "basket" is typically capped at a fixed dollar amount, although, in some cases, it is a percentage of asset value.

Yes. In order to protect the second lien creditors from losing the value of their accrued claims, the typical covenant package in a second lien deal will fix the maximum principal amount of first lien debt that may be incurred. The cap is typically fixed at a specified dollar amount (which typically includes a cushion to allow "protective advances"), but may sometimes be a function of a maximum leverage ratio or other financial test.

Yes. In order to protect the second lien creditors from being diluted, the typical second lien covenant package will cap the borrower’s ability to incur additional second lien debt. The cap is usually based on a maximum leverage ratio or other financial test although it could be expressed as a dollar cap.

The phrase "second lien debt" is a shorthand statement of the relative priorities of the liens securing first and second lien debt. It is not an absolute statement of the priority of the liens securing second lien debt. In reality, the liens securing second lien debt are junior both to the liens securing the first lien debt and certain other liens, usually called "Permitted Prior Liens," which are permitted to rank ahead of the second liens (and possibly the first liens) under the terms of the security documents. The payment of creditors secured by Permitted Prior Liens will generally be baked right into the priority waterfall provisions for distributions of collateral sale proceeds contained in the lien subordination agreement.

As a general rule, Permitted Prior Liens fall into four categories:

• liens securing the first lien debt (and all related "obligations");
• liens that pre-date the second liens (which, in some deals, may include liens that the borrower "inherits" if, for example, it acquires assets in the future that are subject to liens);
• liens securing a specified amount of purchase money debt; and
• liens that are not voluntarily granted by the borrower but arise by operation of law and are entitled by law to priority over the second liens (for example, certain tax and ERISA liens).

Not every one of these categories is appropriate in every deal. The exact definition of "Permitted Prior Liens" will need to be negotiated appropriately to suit the context in each deal. The obligations secured by Permitted Prior Liens can be material and may affect the successful marketing of the transaction.

In some second lien financings, the first lien creditors have given second lien bondholders and second lien lenders an option to purchase the first lien obligations. The exercise price is generally the par value of the outstanding first lien debt plus accrued interest (excluding any amounts payable as prepayment or acceleration penalties or premiums). Usually, the option can be exercised during an agreed time period starting on the date on which the company files for bankruptcy and/or the first lien creditors take any action to foreclose on their collateral. Some second lien lenders and, less often, some second lien bondholders view the purchase option as a "must-have" provision. First lien creditors generally view the purchase option as acceptable since, if exercised, it allows them to exit a troubled credit at par.

The purchase option has some value for the second lien creditors because, once it is exercised, the second lien creditors will no longer be subject to any of the lien subordination arrangements discussed above and will be free to exercise all of the rights of a secured creditor. As a result, the second lien creditors will have increased leverage in the plan or out-of-court restructuring negotiations that may translate into a higher net recovery for the second lien creditors. However, in any restructuring where the second lien creditors are sufficiently organized and able and willing to buy out the first lien position at par, an amicable arrangement will likely be within easy reach. As a result, many market participants do not attribute significant value to including this option in the original documentation.

In most large second lien bond deals, the first and second liens run to, and any possessory collateral is held by, a single independent collateral trustee for the benefit of the holders of the first and second lien debt. In those deals, the lien priority and subordination provisions are contained in the collateral trust agreement. That agreement will also typically provide for the possibility of future first and second lien financings without a need to amend the documentation. In other bond deals and in second lien term loan deals, by contrast, the practice is generally for each of the first and second lien debt holders to have separate collateral agents. The first and second liens are granted to the respective collateral agents, and the first lien collateral agent will hold any possessory collateral for the benefit of both the first and second lien holders. The lien priority and subordination arrangements are governed by an intercreditor agreement signed by the collateral agents for the first and second lien debt.

Because of a single unfortunate case from 1991,²⁰ there is some debate as to whether the first and second liens can be granted in a single set of security documents (containing separate grants of security interests for the first and second liens) rather than in separate sets of security documents. Some first lien lenders are concerned that they may prejudice their right to post-petition interest unless the first and second liens have completely separate security documents. We believe that, if properly documented, a single set of security documents should work to ensure that the first and second lien creditors hold separate secured claims. Each security document should contain two separate granting clauses and a clear statement of an intention to create two separate classes of secured creditors.

As we have discussed above, generally the first lien creditors control (at least for some period of time) many of the key decisions relating to the collateral. Typically, in both second lien bond deals and second lien term loan deals, the collateral trustee(s) are only authorized to take action if instructed to do so by first lien lenders holding more than 50 percent of the total amount of the outstanding first lien debt. Often, the amount of unfunded commitments is not counted for voting purposes in connection with the exercise of remedies on the theory that only the holders of funded first lien debt have "skin in the game."

If there is more than one series of first lien debt outstanding, the first lien creditors need to decide among themselves on how the various series of first lien debt will vote together as a single class. There are two general approaches to this conundrum. The first is the electoral college system, under which each series of debt within a class votes as a block in favor of (or against) the proposed action. The block vote of each series is determined by a majority (or supermajority) of the holders in that particular series. The second approach is the popular vote system, in which all of the debt in a class (regardless of series) votes together as a single class. The popular vote system tends to be less attractive because it does not address the situation where different series of debt have different voting requirements to approve a particular action. One series of debt may require majority approval for a particular action, while another series of debt may require supermajority approval for the same action. By lumping all the series of debt into a single voting group, the voting requirements for the various series of debt may be effectively replaced with a single uniform voting standard that is not consistent with the parties’ bargained for intent.

Second lien financing structures are here to stay. These financings can provide some below-investment-grade companies with access to the capital markets where they would otherwise not have access at all. Other high yield issuers are able to obtain financing on more favorable terms by granting collateral to their junior creditors. However, there can be costs associated with second lien financing structures, and a careful borrower will want to think through the consequences of issuing second lien paper on its ability to tap the debt markets in the future.

Traditional first lien lenders are not predisposed to favor second lien deals, but they have been required to take a more flexible approach to these new financing structures to help reduce their own exposure or to accommodate borrower clients desiring to raise capital in this new way. We do not expect first lien lenders to ever be vocal advocates for securing the claims of their junior cousins in the capital structure, but they can no longer simply ignore these new products.

Second lien bondholders and second lien term lenders are inching their way toward consensus on many of the key structuring points that find their way into the lien subordination agreements that define the rights of second lien creditors in these deals, but we have not yet reached a market equilibrium on every point. High yield bondholders have tended to be more accommodating than many term loan lenders, but much depends on the context of the particular deal and generalizations are rarely conclusive. We have included a chart at the end of this client alert that attempts to capture our view of "the market" as of the Spring of 2004 for your convenience. However, we fully expect the market consensus to evolve over time and you should expect that too.

1 Term loan B’s are a variation on the type of term loans (which are now often called term loan A’s) traditionally made by banks and other financial institutions that want both a steady return of principal (through periodic amortization) and interest payments. Term loan B’s are targeted at, and typically held by, hedge funds and other institutional investors with a longer term investment strategy. As a result, term loan B lenders generally require only nominal, if any, principal repayment on their term loan B’s until the maturity date (or the year prior to maturity), and have the right to refuse all or a specified portion of optional prepayments made by the borrower. If both a term loan A and term loan B are made to the borrower in the same transaction, the interest rate on the term loan B generally will be higher than on the term loan A. If a credit facility contains both a term loan A and term loan B, any optional prepayment amounts not applied to prepay the term loan B typically will be applied to prepay the term loan A. Term loan B’s bear interest at a floating rate (typically), sometimes with specified minimum rates, and have covenant packages that are derived from (and substantially similar to) those found either in the borrower’s traditional bank credit agreement or, in an increasing number of cases, in the borrower’s high yield bond indenture.

2 CBOs, CDOs and CLOs are structured vehicles that issue asset-backed securities, generally secured by debt obligations which may include term loans and high yield bonds. These vehicles have become major players in the secondary debt markets and have played an important role in developing a liquid secondary market for term loans and high yield bonds. For tax reasons, these vehicles do not invest in the primary debt offering, but will often acquire debt securities in the secondary market within a few days after the initial offering. Since 2003, CBOs, CDOs and CLOs have been incorporating second lien term loans and second lien bonds in their portfolios. As investors, rating agencies and other market players have become more familiar with second lien financings, their treatment in CBOs, CDOs and CLOs has been evolving and continues to evolve. Nevertheless, second lien term loans and second lien bonds are and will continue to be a part of the portfolios of many CBOs, CDOs and CLOs.

3 Anti-layering covenants are more typically found in bond indentures than in bank loan facilities.

4 The exact wording of each anti-layering covenant must be examined carefully to determine whether second lien debt will be permitted.

5 Under the bankruptcy code, all unsecured claims are not treated equally. Certain unsecured claims, called priority unsecured claims, have the right to be paid in full before any of the residual unsecured claims, called general unsecured claims, are paid. Priority unsecured claims include:

• post-petition administrative expenses needed to operate the bankrupt company (such as employees’ wages and other ordinary course operating expenses) or to pay lawyers, accountants and other professionals hired by the bankrupt company or certain types of creditors;
• in an involuntary bankruptcy, "gap" claims, which are ordinary course unsecured claims incurred between the bankruptcy filing date and the appointment of a trustee or entry of an order for relief;
• certain pre-petition employees’ wages;
• certain contributions to employee benefit plans; and
• certain types of tax claims.

6 Any three unsecured or undersecured creditors can commence an involuntary bankruptcy case against a company if the total value of their claims against the company is at least $11,625 more than the total value of their interests in assets of the company pledged to secure those claims.

7 There are numerous exceptions to this general rule, including for liens securing purchase money debt and certain tax, ERISA and other statutory liens. In addition, with respect to many types of collateral, certain methods of perfection, such as possession or control, may be entitled to priority over an earlier security interest that is perfected solely by the filing of a financing statement.

8 We are not aware of a general fiduciary duty owed by a senior secured creditor to a junior secured creditor simply by having a senior lien on common collateral.

9 The UCC covers most types of tangible and intangible personal property. Some of the significant categories of property not covered by the UCC include:

• real estate (other than fixtures),
• some types of intellectual property and
• in most states, insurance policies and any claims under those policies (other than as proceeds of other collateral).

10 The first lien debt generally does not provide a reciprocal waiver of its right to challenge the second liens. As a practical matter, first lien lenders will often be reluctant to challenge the second liens out of concern that a challenge could boomerang back on them. The first and second liens tend to be granted under the same set of security documents or under separate but substantively identical security documents. If there is a flaw in the security documents that impairs the second liens, there is a good possibility it will also impair the first liens.

11 In the early stages of a case a debtor may have no source of liquidity for operations other than cash collateral. As a result, if the debtor is denied the use of cash collateral it may be required to cease operations and liquidate. As a practical matter, if a bankruptcy court is faced with either permitting use of cash collateral over a secured creditor’s objection or causing the debtor to liquidate, the bankruptcy court will routinely permit use of cash collateral. Thus, as discussed in the text accompanying this note, first lien lenders tend to concentrate their efforts not on seeking to prevent such use, but rather on requiring that such use be conditioned on the debtor’s adherence to a tight operating budget.

12 Unless the court orders otherwise, at the auction, the second lien creditors can "credit-bid" (i.e. reduce dollar for dollar the cash price payable by the second lien creditors for the auctioned asset by an amount equal to) the value of their interest in the collateral in excess of the value of the first lien creditors' interest in the collateral. For example, assume that the bankrupt company owes $50 to the first lien creditors and $200 to the second lien creditors. Both the first and second lien debt is secured solely by liens on an asset worth $150. If a third party makes a cash bid of $120 for one of the bankrupt company’s crown jewels, and there are no other bidders, the first lien creditors will likely favor the sale because they will get paid off in full. By credit-bidding, the second lien creditors are only required to cash-bid $50 (the value of the first lien creditors’ interest in the collateral) and can credit-bid up to the full amount of their $200 debt. Credit-bidding allows second lien creditors to lower the cash component of their bid, which gives them a competitive advantage over other bidders without credit-bid rights.

13 In theory, the court could construct a plan providing for first and second lien creditors to share in a defined pool of value and leave them to sort out their intercreditor relationship after the plan is confirmed and consummated. That is not a likely result in practice since it would be difficult to obtain the approval of the creditors affected by such a classification.

14 In reality, waiving the right to challenge the first liens may not be as big of a concession as it might appear at first blush. As discussed in note 10 above, the first and second liens are often granted at the same time and under either a single set of security documents or separate sets of near identical security documents. If the first liens can be successfully challenged, there is a reasonable chance the same case can be made against the second liens.

15 Typically, the second lien documents will also provide for the concurrent release of any subsidiary guarantee upon the sale of all of the stock of that subsidiary or the sale of all or substantially all of the assets owned by that subsidiary.

16 Other common exceptions to a "blanket lien" include one-third of the stock of certain foreign subsidiaries, and certain licenses issued by governmental authorities (such as liquor licenses or FCC licenses). These and other exceptions from the "blanket lien" are often heavily negotiated and vary from deal to deal.

17 Some earlier deals tried to steer clear of the annual audit requirement by including a general statement that the second lien debt would not be secured by stock of subsidiaries or intercompany loans to the extent the pledge of those securities would trigger the audit requirement. However, the SEC has not favored this fall-away mechanism and those issuers with indentures containing this mechanism have faced extensive SEC comments during the registration process.

18 See the SEC’s order granting Allied Waste North America, Inc.’s application for an exemption from TIA Section 314(d) dated August 8, 2001 (Trust Indenture Act of 1939 Release No. 2392). There, the SEC staff agreed that Allied Waste was under no obligation to deliver certificates or opinions of fair value upon any release of collateral from the lien since neither the indenture trustee nor the holders of the indenture securities had any control over these decisions. All such decisions were controlled by the first lien creditors.

19 The filing of a financing statement does not perfect a security interest in money, deposit accounts letter of credit rights as original collateral and, in most cases, motor vehicles (except to the extent those assets are proceeds of other collateral), real property (other than fixtures) or any personal property excluded from Article 9 of the UCC.

20 The case is called In re Ionosphere Clubs, Inc., 134 B.R. 528 (Banker, S.D. N.V. 1991). In that case, three series (series A, B and C) of creditors had a security interest in the same assets of the bankrupt company. The security interest for each of the series A, B and C creditors was granted in the same security agreement. The security agreement contained a single "granting clause" that granted one security interest in favor of the series A, B and C creditors. The issue at stake in the case was whether the series A, B and C creditors held three separate secured claims or were co-owners of a single combined claim. The answer would determine whether the series A creditors were entitled to post-petition interest.

In bankruptcy, only an oversecured creditor is entitled to post-petition interest. A creditor is oversecured if the value of its interest in its collateral exceeds the amount of its claim. If the series A, B and C creditors each held a separate secured claim, the series A creditors would be oversecured and the series B and C creditors would be undersecured. However, if the series A, B and C creditors were co-owners of a single combined secured claim, the entire class, including the class A creditors, would be undersecured.

The bankruptcy court held that the series A, B and C creditors were co-owners of a single secured claim because the series A, B and C creditors were secured by a single security interest. The court stated that, if the three series had been secured by three separate liens on the collateral, there would have been three separate secured claims.