It’s difficult to predict exactly what major legal issues will arise in the next economic cycle, however, we do expect that in the next downturn there will be an increased number of chapter 11 cases, many of which will be marked by disputes among creditors.
One of the consequences of “covenant light” debt documents—which have become common again in the market—is that they lack early tripwires that would force companies to confront signs of financial distress. As a consequence, we expect to see many companies drift through the early stages of financial distress, and to start looking for solutions at a point where the only viable source of new liquidity are debtor in possession financing loans that prime existing indebtedness in a chapter 11 case.
When preparing for the next downturn, careful attention should be paid to intercreditor agreements that govern the relationship among secured creditors and situations where the size of secured claim can unexpectedly grow beyond stated principal (for example, due to a make-whole provision in a debt document). Although intercreditor agreements are intended to limit the potential for litigation and result in predictable commercial outcomes, the interpretation of these agreements recently has been the subject of substantial bankruptcy litigation.
An intercreditor agreement defines creditors’ relationships with each other in connection with their claims against an obligor and its assets, and also defines the rights of each creditor as to the priority of payment or liens. For example, in intercreditor agreements, creditors typically agree not to challenge each other’s liens and relative priorities in payment and distribution. Intercreditor Aareements also may include a covenant by a subordinated creditor to turn over payments that it receives from the obligor to senior creditors.
From a legal standpoint, the Bankruptcy Code provides that subordination agreements—which include intercreditor agreements—are enforceable to the same extent as they would be enforced under applicable non-bankruptcy law. Bankruptcy courts, thus, generally will enforce intercreditor agreements, particularly when provisions in the intercreditor agreement specifically govern the issues before the court.
The interpretation of intercreditor agreements has been the subject of bankruptcy litigation. For example, one court recently found that a payment waterfall provided for de facto claim subordination, even though there was no express claim subordination provision in the document.
If upheld on appeal, this decision should give junior creditors pause given the breadth of the court’s subordination interpretation, and may provide senior creditors with significant leverage in situations where there is any ambiguity in the intercreditor agreement as to whether the waterfall applies solely to collateral proceeds.
Provisions for Intercreditor Agreements
Senior creditors typically should include provisions in intercreditor agreements that protect their rights against subordinated creditors, and also contemplate an obligor’s bankruptcy filing.
Some examples include:
- Providing for cross-default provisions and for provisions that restrict junior creditors from amending credit agreements without the senior creditor’s consent;
- Requiring junior creditors to consent to the obligor’s use of cash collateral in a bankruptcy proceeding to the same extent of the senior creditor’s consent; and
- Requiring junior creditors to consent to the senior creditor providing DIP financing up to an agreed amount.
Junior creditors, on the other hand, typically should negotiate for provisions to restrict senior creditors’ actions that could prejudice the junior creditors’ subordinated provisions.
Some examples include:
- Limiting the amount of debt an obligor may incur from a senior creditor;
- Restricting the time that any standstill or payment block period may be in effect;
- Including cross-default provisions; and
- Providing, in contemplation of an obligor’s bankruptcy, for the right to contest a senior creditor’s cash collateral arrangements, particularly if the junior creditors have agreed to waive their right to contest the senior creditor’s right to adequate protection payments.
Careful Attention to Make-Whole Language
A make-whole provision, in short, is a clause typically contained in an indenture that compensates bondholders for the loss of future interest payments in situations where the borrower voluntarily prepays its debt obligations (for example, because of declining interest rates). Make-whole provisions protect lenders by allowing for prepayment in exchange for a sum that is intended to compensate the lender for the loss of its bargained-for investment yield.
In low interest environments, as we currently are in, a make-whole claim can be substantial as it would be difficult for a creditor to re-deploy funds it receives at a comparable interest rate. As a result, the outcome of litigation over make-whole provisions can dramatically swing creditor recoveries.
The interpretation of make-whole provisions remain a significant issue that can result in litigation. By definition, make-whole payments are not payable upon maturity of a debt obligation. In bankruptcy, where debt documents frequently provide for an automatic acceleration (or where automatic acceleration arguably occurs de facto), the question frequently arises whether such a maturity occurring prior to the stated maturity is the valid basis for activating the make-whole provisions.
For example, courts have held that in documents which provide that the debt is deemed to have matured as a result of an automatic acceleration in the event of a bankruptcy filing, the creditors were not entitled to the make-whole payment, because it constituted a payment upon maturity that negated any right to a make-whole premium. Likewise, the Second Circuit denied a make-whole claim where the underlying documents provided that the make-whole premium only was due in the case of an optional redemption, and not in the case of an acceleration brought about by a bankruptcy filing.
Courts generally have held that agreements containing clear contractual language providing that a make-whole premium is payable even in the event of an automatic acceleration upon a bankruptcy filing are enforceable.
Generally, language similar to the following has been found to be sufficient to allow for payment of a make-whole premium: The make-whole premium is due and payable, notwithstanding automatic acceleration for any event (including, but not limited to, a bankruptcy filing), if the notes are repaid at any time before their original maturity date.
As restructuring professionals speculate that a recession looms near, the industry continues to closely monitor certain key contractual provisions in intercreditor agreements as well as make-whole provisions, and how the interpretation of such provisions may result in substantially different recoveries for creditors.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Fredric Sosnick is the Financial Restructuring & Insolvency team leader at Shearman & Sterling. He focuses on advising clients in connection with large and complex domestic and international out-of-court restructurings and U.S. Chapter 11 cases and represents debtors, official creditors’ committees, lender groups, DIP lenders, hedge funds, creditors and acquirers of assets. His clients include Bank of America, Barclays, Citigroup, and Deutsche Bank, among others.