Number

382

April 15, 2004

Alert
Latham & Watkins Corporate and Finance Departments

Second Lien Financings-Answers to the Most Frequently Asked Questions
The purpose of this client alert 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 client alert, 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 client alert, 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.

II

There is 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. II

What is a Second Lien Term Loan?
A typical second lien term loan is a "term loan B'" 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

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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.

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.

What is a Second Lien Bond Deal?
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.

What are the Pros and Cons of a Second Lien Deal for a Company?
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, CEO, CDO and CLO funds and hedge funds." For some companies, this deeper level of market interest can difference between able to do a deal and not access to
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Why Would a First Lien Creditor Want to Permit a Second Lien Deal?
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 In addition, their

In lien subordination. we need to explore some information about what 3 Number 382 I April 15. In terms of payment priority. in turn. under the lien subordination agreement in most deals. covenant issues. However. in the first place. In traditional contractual subordination. Some Important Background Information So far. We will then discuss which of these rights second lien bondholders and second lien lenders may be willing to part with. it agrees to turn it over to the holders of "senior debt" until the senior debt is paid in full. at least typically. These players believe that second lien debt holders should only speak when they are spoken to. the underlying debt claim is not. In addition. This is the key benefit for the second lien creditors. Others would characterize "silent second" lien financings as "quiet seconds.Silent Second" Lien? Even a "silent second" gives a second lien creditor effective priority over trade creditors and other unsecured creditors. 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. it also places the second lien debt ahead of the trade and other unsecured creditors. We have also said that second liens are." In order to address that critical question. "silent seconds." These players are willing to defer to first lien holders up to a point or for a limited period of time. A typical "anti-layering" covenant' 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. the second lien creditors expressly reserve all of the rights of an unsecured creditor. 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. but does not place it ahead of any other debt of the borrower (unless holders of that other debt agree. a typical anticovenant does not restrict the incurrence of second lien debt because Anti-layering Why Would a Junior Creditor be Willing to Accept a ." So where's the controversy? Well. to the extent of the value of its interest in the collateral. subject to some important exceptions. Priority vis-a-vis the trade. 2004 . 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. to subordinate their debt to the subordinated debt). the debt claim itself is subordinated. This leaves the second lien creditors with a "silent second" lien. If a subordinated debt holder obtains anything of value in a bankruptcy from any source. In its simplest terms. All the action in the structuring and negotiating of second lien deals revolves around the determination of how silent is "silent. the key question is "How silent is silent?" Some market participants are from the old school of senior lending. up to the value of its interest in the collateral. debt subordination places the subordinated debt behind the senior debt. we have established that second lien debt holders get paid second when it comes to proceeds of collateral.. but no more. "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. By contrast. What is the Difference Between Debt Subordination and Lien Subordination? Basics. the liens are subordinated.Latham & Watkins I Client Alert 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.

sales of collateral. 2004 . In the case of bond deals issued in public offerings (or in private placements with registration rights). Under the bankruptcy code. Under the bankruptcy code.Latham & Watkins I Client Alert it isn't subordinated "in right of payment. 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. Remedy standstill provisions. For example. Under the bankruptcy code. Most second lien deals specifically preserve all or almost all of the remedies that would be available to an unsecured creditor. Post-petition interest. The second lien creditor's 4 Number 382 I April 15. As a result. remaining after repayment in full of both secured claims and priority unsecured claims. the Trust Indenture Act prohibits any bar on actions to collect payments due and owing to bondholders." A second lien creditor's claim is treated as a secured claim to the extent of the value of its interest in the collateral. Upon request. Adequate protection rights. Unlike traditional subordinated debt. secured creditors have a variety of meaningful rights that unsecured creditors don't have. The remedy bars in second lien deals typically only apply to remedies associated with the collateral. In this case. in turn. What Rights do Secured Creditors Gain? In a bankruptcy proceeding. in the example discussed above.e. As a result. and (3) general unsecured claims. 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. thereby reducing the likely recovery by the second lien creditor.'" Payment blockage issues. if any. secured creditors are entitled to assurance that their collateral is protected In a Bankruptcy. the first lien creditor will have a $50 secured claim and no unsecured claim. As a result. secured creditors enjoy significantly higher recovery rates in bankruptcies and other reorganizations than unsecured creditors.. Priority vis-a-vis the trade and other unsecured creditors. To the extent a secured creditor is "undersecured" (i. creditors' claims can generally be divided into three basic classes: (1) secured claims. with a few exceptions (as we will discuss below). an "undersecured" creditor will hold both secured and unsecured claims. substitutions of collateral or the grant of a priming lien on collateral to secure a DIP financing). 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. second lien debt is not typically subject to payment blockage provisions of any kind. 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. and any priority unsecured claims are entitled to receive the full value of their claims before any general unsecured claims receive any value. residual $100 claim will be treated as a general unsecured claim. The second lien creditor. 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. An undersecured creditor is not entitled to post-petition interest. 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. will have a secured claim of $100. (2) priority unsecured claims. 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. but it does allow limits on enforcement actions against collateral.

unless the bankruptcy court orders otherwise. The bankruptcy court has broad discretion in fashioning an appropriate remedy in this regard. More leverage in plan negotiations. the creditors in each class have the right to vote on any proposed plan of reorganization." It is generally much harder for a class of secured creditors to be "crammed down" in a bankruptcy than a class of unsecured creditors. If more than one party has a lien on the collateral. a plan of reorganization can be confirmed over the objections of a particular class of creditors. and • the right to challenge the validity. 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. after notice and a hearing. under certain circumstances. enforceability or priority of any liens on the company's assets. Right to approve secured DIP iinancings." In a bankruptcy. Right to object to use of cash collateral. 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. "Cash collateral" is a defined term in the bankruptcy code and includes cash. including: • the right of any three unsecured or undersecured creditors to put a company into an involuntary bankruptcy. 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. However. This gives each secured creditor a say on the use of cash collateral. each of the secured creditors may be required to consent to the sale. free and clear of all liens. As a result. A company in bankruptcy needs funds to operate. Under the bankruptcy code. Under the bankruptcy code. 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. What Rights do Unsecured Creditors Have Outside of Bankruptcy? Unsecured creditors (as well as secured creditors) have several important rights outside of bankruptcy.' • the right to accelerate their debt and sue for payment. many bankrupt companies have negative or marginal cash flow. which prompts the need for "debtor-inpossession" or "DIP" financing arrangements. as long as those other secured creditors are adequate protection or consent to the 5 Number 382 i April 15. Right to approve asset sales. The standard for what is fair and equitable is higher for secured creditors than it is for unsecured creditors. As a result. A class of creditors that is forced to accept the terms of a plan that it voted against is said to be "crammed down. 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. deposit accounts and other cash equivalents in which a pre-petition creditor has a security interest. negotiable instruments. Under the bankruptcy code. a company in bankruptcy can sell assets. unsecured creditors need to be reckoned with and will be "at the table" in any out-of-court restructuring . but are generally secured on a first priority basis. which gives secured creditors greater leverage at the bargaining table in bankruptcy plan negotiations. in certain circumstances. DIP financings can be secured or unsecured. Harder to be "crammed down. 2004 prior or equal liens. a class of creditors can only be crammed if the plan of reorganization is "fair and equitable" to that class. the consent of a secured creditor to a sale of its collateral may be required. in various circumstances. For obvious reasons.Latham & Watkins I Client Alert there is a serious risk of its diminution in value. securities. However.

in certain cases. 2004 A secured creditor does not have an unfettered right to dispose of collateral. the rights of an unsecured creditor in bankruptcy are significantly less than those of a secured creditor. 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. • 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. . In addition. As a result. if any. The second in time is second in line.g. they are enough to give unsecured creditors a "seat at the table" in the plan negotiations. first-in-line..e. • to challenge the validity. The UCC contains a variety of substantive and procedural requirements governing foreclosure on personal property collateral that is subject to the UCc. If the second lien creditor forecloses on the asset. However. few buyers in a foreclosure sale are willing to buy an asset subject to a first lien.. or UCC. 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. If the first lien creditor forecloses on the asset. the first to "perfect" its security interest in an asset gets the first priority lien on that asset.Latham & Watkins I Client Alert process if they are not being paid current interest. any secured creditor or any other interested party. as between two secured creditors. as a practical matter. remaining after repayment in full of the claims of the secured creditor that forecloses on the collateral. because the bankrupt company is mismanaging the business). by the bankrupt company. enforceability or priority of any liens on the bankrupt company's assets. What Rights do Unsecured Creditors Have in a Bankruptcy? Unsecured creditors (as well as secured creditors) have other meaningful rights during a bankruptcy. Although.' Priority is important because it determines the order of repayment when the collateral is sold or otherwise disposed of. Restrictions on dispositions of collateral. 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). What are the Relationships Between Multiple Secured Creditors at Law (i. and few first lien creditors are willing to release their first liens unless their debt has been repaid in full. including: • to request the appointment of a trustee in bankruptcy (e. or any motions made. 6 Number 382 I April 15. These rules effectively limit the ability of a secured creditor to conduct collateral "fire sales. a first lien creditor may owe fiduciary duties" to the second lien creditor. If two creditors are secured by liens on a asset.' Most under the UCC. • to vote on a plan of reorganization. Under that general rule. unless otherwise agreed by those creditors." Rules governing foreclosure on UCC collateral. particularly where the first lien creditor has agreed to serve as agent for the second lien creditor. 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.Ull of collateral . the first lien remains in place on the sold asset and the second lien creditor is entitled to the foreclosure proceeds. and other applicable laws is that either creditor has the right to foreclose on the asset.JU"lLJ. generally. Absent an Intercreditor Agreement)? Order of priority. and • to challenge or dispute any other actions taken or not taken. the rule under the Uniform Commercial Code. The general rule is first-in-time. Control over enforcement actions.

supervised by a state court. 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. 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. are subject to overbidding and bankruptcy court scrutiny and approval. These duties to creditors are a further limit on the likelihood that collateral will 7 Number 382 I April 15. A company in bankruptcy clearly falls within the zone of insolvency. Second lien bond deals tend to be more "silent" than second lien term loan deals. In some states. in practice. we will now turn to a series of specific questions about how to structure a second lien financing. What Makes a "Silent Second" Silent? 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. with respect to their liens (possibly subject to time or other limitations). n Directors and officers of a Structuring Questions With that background discussion behind us. and primarily." those fiduciary duties are additionally. However." as they are commonly known. " Rules governing foreclosure on real property collateral. However. with a view to achieving the best available sale price. However. These "363 sales. As a general matter. The substantive and be disposed of in haste at significantly below its fair market value. During a bankruptcy. agreements by the holders of second liens not to enforcement or foreclosure actions taken the company owe a fiduciary duty to the company's shareholders to act in what they reasonably believe to be the hest interests of the shareholders. with limited exceptions. procedural requirements that govern foreclosure of real property collateral vary from state to state. In most states.Latham & Watkins I Client Alert must be "commercially reasonable. owed to the company's secured and unsecured creditors. if the company enters the "zone of insolvency. Fiduciary duties in the "zone of insolvency. Asset sales are governed by Section 363 of the bankruptcy code. 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). Bankruptcy code restrictions. 2004 . .." 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 uee. a secured creditor can foreclose on real property through a judicial foreclosure. a company can also be in the zone of insolvency as it approaches bankruptcy. The bankruptcy code also imposes its own set of restrictions on asset sales. the company in bankruptcy decides which assets to sell (albeit. 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 uee requirements also effectively limit the ability of any secured creditor to sell collateral at a "fire sale. As a rule of thumb. a secured creditor generally does not have a right to compel sales of collateral. 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. following discussions with its secured creditors). If the sale is conducted through a judicial foreclosure.

Bond buyers are typically more focused on getting priority over trade creditors than on retaining any particular rights in a bankruptcy case. the bonds may expect to have an active (and possibly even controlling) voice in the exercise of remedies under the security agreements." 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. The longer answer depends. if the first lien lenders have not taken steps to exercise remedies against the collateral when the standstill period expires. and • advance consents to DIP financings. H to seek "adequate First. the first lien lenders lose their monopoly on the exercise of secured creditor remedies. following a default on the first lien debt. • advance consents to sales of collateral. What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive During the Period Before a Bankruptcy Filing? The answer to this question depends on the context. again. second lien lenders will only agree to refrain from exercising their secured creditor for limited time. At the end of the standstill period. • whether the sale should be a public or a private sale. 2004 period of time is often referred to as a "fish-or-cut-bait" or "standstill" period. giving the second lien lenders the monopoly on remedies. 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. However. • which items of collateral to proceed against and in which order. the second lien creditors tend to be truly "silent. in a second lien term loan deal." Generally. enforceability or priority of the first liens. among other things: • whether and when to exercise remedies against the collateral." What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive in a Bankruptcy? The short answer is all of the same rights they waive before bankruptcy (see above). As a result. Both second lien term lenders and second lien bondholders typically waive their right to challenge the validity. The following waivers and consents are commonly seen in lien subordination agreements in both the bond and term loan markets: • adequate protection waivers. In a small number of deals. This 8 Number 382 I April 15. • advance consents to use of cash collateral. let's look at the bond . subject to the uee. the first lien lenders typically decide. 90 to 180 days.Latham & Watkins I Client Alert holders of the first liens (possibly subject to time or other limitations). the second lien is often more in the nature of a "quiet second. they forfeit any further right to take remedies. Waiver of the protection. There are many variations on the scope and duration of these temporary standstill arrangements. By contrast. plus some others. The post-bankruptcy waivers tend to be broader in second lien bond deals than in second lien term loan deals. on the context. and • to whom collateral should be sold and at what price. In a second lien bond deal. and • waivers of (or limitations on) other secured creditor rights by the holders of second liens. bankruptcy code and other legal limitations discussed above. • prohibitions on the right of the second lien holders to challenge the validity or priority of the first liens. If there is significantly more second lien bond debt in the capital structure than first lien bank debt. 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.

assets on which additional or replacement liens can be granted to protect the value of the original liens. Excluding the ability to have a say in the use of cash collateral and DIP financings (which we will discuss below). This right is of critical importance to a holder of liens on "quick assets" (as discussed above). 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. there is strong resistance by some participants in the institutional term loan market to agree to any adequate protection waivers. particularly where there are second lien term loans and pari passu second lien bonds with similar (or even identical) covenants. 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. dollar for dollar. the term loans will waive their protection fights tor so as any first lien debt is in the same way that the 9 Number 382 i April 15. as long as the new junior lien is subject to the same lien subordination arrangements as the original second lien. The remedy is of more limited utility to a second lien creditor that already has a lien on all of the borrower's assets. This right is critical to avoid erosion of the second lien bondholders' bargained-for collateral. 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 waiver of the seek other forms of . 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. to assets acquired or arising after the commencement of the bankruptcy proceeding. It is unclear at this point where the second lien loan market will settle on this important issue. In most cases. and it is also meaningful if the company in bankruptcy has valuable unencumbered. The market is less settled for second lien term loans. In some cases. However. As a result. The value of the second lien creditors' interest in any additional or substitute collateral obtained to secure second lien obligations increases. However. 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. the first lien lenders can be counted on to make this request (typically phrased as an adequate protection motion). In general. or partially encumbered. the amount of the secured claims held by the second lien creditors.Latham & Watkins I Client Alert market. On balance. or apply. under the bankruptcy code. in many cases. 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. 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. 2004 bonds waive these rights. liens created prior to a bankruptcy generally do not attach. however. However. 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. The practical significance of these adequate protection waivers depends on the facts of the case. However. giving up the opportunity to obtain additional or substitute collateral in the name of adequate protection could have real-world cost. 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. with some limitations.

However. at which the second lien creditors can bid. 2004 . but only if the liens securing the DIP financing rank prior or to the liens the first lien debt. If the second lien debt is undersecured. since a company in bankruptcy invariably cannot operate without access to cash and other cash collateral. Advance consent to the use of cash collateral. lien debt. This advance consent appears in various permutations: • unconditional consent to any DIP financing approved by the first lien creditors. 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. and frequently do. without regard to the company's prospects of emerging from bankruptcy. By providing an advance consent to asset sales. 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. is much more likely to be oversecured and will often want a quick liquidation of the bankrupt company's assets. 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. subject to a dollar cap (which typically includes a cushion to allow "protective advances") on the amount of the DIP financing. 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." Advance consent to sales of collateral. 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). Waiver of the right to oppose "adequate protection" for the first lien debt. Second lien term lenders and second lien bondholders typically agree to some form of advance consent to DIP financings. it may be relying on a successful reorganization of the debtor for repayment of its debt. the second lien debt will almost certainly be required to rely on the first lien creditors to handle these budget negotiations. and • conditional consent to any DIP financing approved by the first lien creditors. with no cap on the amount of the DIP financing. This waiver is not particularly controversial and is not usually subject to any time limitation. • conditional consent to any DIP financing approved by the first lien creditors." and the fiduciary duties and other legal requirements discussed above should prevent most of the potential for mischief from ever coming to fruition. Second lien term lenders (but generally not second lien bondholders) may additionally condition their advance consent on the use of all or a of the sale proceeds to permanently reduce the first 10 Number 382 ! April 15. condition access to these funds on adoption by the company in bankruptcy of a satisfactory operating budget. Secured creditors can. on the other hand. the second lien debt no longer has any say as to sales of collateral approved by the first lien debt. As a result of this advance consent. Advance consent to DIP financing approved by the first lien debt. The first lien debt. 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).Latham & Watkins I Client Alert on their own will not prove to be an imprudent concession in most real-world circumstances.

both before and during a bankruptcy. and it is acceptable to first lien creditors and borrowers because it does not arbitrarily cap the amount of the DIP financing. use of cash collateral. such as with respect to adequate protection. the subordination provisions are usually documented in an intercreditor agreement. and (2) an agreement not to oppose a plan supported by the first lien creditors. 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. 2004 Typically. a lien subordination agreement containing the types of provisions discussed above should be enforceable most bankruptcy courts will not monitor 11 Number 382 I April 15. however. The right to vote on a of reorganization provides significant . This permutation is generally a reasonable and fair compromise from the perspective of all parties involved. compliance with every aspect of the advance waivers and consents contained in a lien subordination agreement. Typically. The bankruptcy code specifically says that a subordination agreement is as enforceable in a bankruptcy as it is outside of bankruptcy. We have seen first lien creditors go even further.. while others use an intercreditor agreement.Latham & Watkins I Client Alert The third permutation is becoming increasingly popular. In practice. As a general matter. unless the first lien creditors vote in favor of the plan or the plan meets certain conditions (e." As a court of equity. the choice of document is a distinction without a difference-it doesn't affect the terms of the subordination agreements themselves. even where the company is in bankruptcy. Substantively. except any rights they expressly waived in the lien subordination agreement. DIP financings and the right to challenge the first liens. 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.. 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. Does a . Most of the larger second lien bond deals have employed an independent collateral trustee.g. This latter method is more common in the term loan market. a lien subordination agreement expressly states that. leaving the first lien creditors to sue the second lien creditors in state court for breach of contract damages. a bankruptcy court may well allow the second lien creditors to assert rights they agreed to waive in the lien subordination agreement. 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. the second lien creditors can take any actions and exercise any rights that they would have had if they were unsecured creditors. that the first lien debt gets repaid in full). 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. Is There a Preferred Way to Document These Lien Subordination Agreements? Some deals reflect the lien subordination terms in a collateral trust agreement. Conversely. where the parties prefer to have separate entities hold the first and second liens. These voting agreements are more controversial and may not be enforceable." We think these limitations are appropriate.Silent Second Lien Creditor Ever End up Worse Off Than an Unsecured Creditor? rr Are Lien Subordination Agreements Enforceable? Courts are generally willing to enforce lien subordination agreements between a company's creditors. sales of collateral.

This last approach is the middle ground and is where we expect the second lien bond market to settle. However. • In other deals. Who Controls Releases of Collateral Outside of Bankruptcy? Generally. 16 In general. won't agree to allow the first lien debt to control the release of any of their collateral. we believe there are three broad approaches to this issue: • In some bond deals. 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. Furthermore. • In still other deals. 15 There is less consensus as to who controls releases of collateral outside of the sale context. 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. with very limited exceptions. the second lien documents provide for an automatic release of the second liens on any collateral upon a sale of that collateral. In the high yield bond market. releases of collateral from the second liens are only allowed if permitted under the documents governing both the first and second lien debt. 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. there will tend to be very few (if any) differences between the collateral securing the first lien debt and the collateral securing the . the first lien creditors can release any or all of the collateral on behalf of both first and second lien creditors at any time. 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. certain categories of assets may be excluded from the second lien collateral. The second lien creditors will generally expect to have a lien on all of the assets securing the first lien debt. the second lien collateral will not include any assets excluded from the first lien collateral.Latham & Watkins I Client Alert protections for a secured creditor. Who Controls Releases of Collateral During a Bankruptcy? During a bankruptcy. First and second lien creditors have very different interests and they frequently (and often strongly) disagree on the merits of a proposed plan. in which case. or the borrower is unable to obtain contractually-required third party consents to the grant of the first liens. the first lien creditors can release collateral on behalf of both the first and second lien creditors. whether bondholders or term loan providers. possibly subject to the requirements of an agreed "asset sale" covenant. the market standard seems clear. 2004 Do Second Lien Holders Get the Same Collateral as First Lien Holders? Generally. unless it involves "all or substantially all" of the collateral. 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. If the second lien debt consists solely of term loans. the first lien debt will hold a "blanket lien" on all assets of the borrower and the guarantors. and generally 12 Number 382 I April 15. Holders of second lien loans. on the other hand. both the first and second lien debt must approve the release. have a different perspective. The second lien holders. depending on the type of debt making up the second lien debt.

" 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. 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. What are the Legal Issues Limiting the Scope of the Collateral Package in Second Lien Bond Deals? There are two sets of restrictions that apply only to registered bonds or bonds that are subject to registration rights. appraiser or other independent expert. 17 Second. First. if the second lien debt consists of or includes registered bonds or bonds sold with registration rights. second lien bondholders have often been persuaded to accept a more limited collateral package than the first lienholders. 2004 creditors control over the "on/off" switch for both the first and second liens. however. those certifications and opinions must be provided by an independent engineer. 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. 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 the of a VCC financing statement (up to . Generally. 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. there may be important differences between the first lien and second lien collateral packages for the legal and practical reasons discussed below. In an exemptive order granted by the SEC in 2001.~~Ah'C is to the first lien 13 Number :382 I April 15. In particular.Latham & Watkins I Client Alert second lien term Ioans. What are the Practical Considerations Limiting the Scope of Second Lien Note Collateral? 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 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. The state of the current law is less than entirely clear. although the SEC orders granting the ordinary course exemptions are not as as be o-ervor-t orv Another way out of the Section "r. In a deal where the first lien creditors do not have authority to release liens on behalf of both first and second lienholders. 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. In most cases. As a result. However. However. subject to limited exceptions. no certificates or opinions will be required for releases of collateral in the ordinary course of business. 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. 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 can be made by an officer of the issuer. 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). 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.

the typical second lien covenant package will cap the borrower's ability to incur additional second lien debt. In order to protect the second lien creditors from being diluted. In reality. the first lien creditors have given second lien bondholders and second lien lenders an option to purchase the first lien obligations. less often. the second lien creditors Are there other "Permitted Prior Liens"? The phrase "second lien debt" is a shorthand statement of the relative priorities of the liens securing first and second lien debt. may include liens that the borrower "inherits" if. 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).Latham & Watkins I Client Alert some agreed cap}. for example. once it is exercised. 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. 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. if exercised. it acquires assets in the future that are subject to liens). Not everyone of these categories is appropriate in every deal. in some deals. although. but may sometimes be a function of a maximum leverage ratio or other financial test. it is a percentage of asset value. some second lien bondholders view the purchase option as a "must-have" provision. it allows them to exit a troubled credit at par. Usually. the typical covenant package in a second lien deal will fix the maximum principal amount of first lien debt that may be incurred. • liens that pre-date the second liens (which. • liens securing a specified amount of purchase money debt. It is not an absolute statement of the priority of the liens securing 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 exact definition of "Permitted Prior Liens" will need to be negotiated appropriately to suit the context in each deal. As a general rule. Permitted Prior Liens fall into four categories: • liens securing the first lien debt (and all related "obligations"). 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." which are permitted to rank ahead of the second liens (and possibly the first liens) under the terms of the security documents. First lien creditors generally view the purchase option as acceptable since. Some second lien lenders and. Are There any Limits on the Amount of Future Second Lien Debt? Yes. The cap is typically fixed at a specified dollar amount (which typically includes a cushion to allow "protective advances"). 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 14 Number 382 I April 15. in some cases. Can the Second Lien Creditors Purchase the First Lien Obligations? In some second lien financings." This general "basket" is typically capped at a fixed dollar amount. Are There any Limits on the Amount of Future First Lien Debt? Yes. The purchase option has some value for the second lien creditors because. certain tax and ERISA liens). In order to protect the second lien creditors from losing the value of their accrued claims. 2004 . The obligations secured by Permitted Prior Liens can be material and may affect the successful marketing of the transaction.

The second Do We Need Two Sets of Security Documents? Because of a unfortunate case from 1991. The first is the electoral college system. and the first lien collateral agent will hold any possessory collateral for the benefit of both the first and second lien holders. In those deals. We believe that. 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. in both second lien bond deals and second lien term loan deals. The first and second liens are granted to the respective collateral agents. 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. many market participants do not attribute significant value to including this option in the original documentation. 2004 . generally the first lien creditors control (at least for some period of time) many of the key decisions relating to the collateral. by contrast. and any possessory collateral is held by. As a result. There are two general approaches to this conundrum." If there is more than one series of first lien debt outstanding. a single set of security documents should work to ensure that the first and second lien creditors hold separate secured claims. 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. the first and second liens run to. under which each series of debt within a class votes as a block in favor of (or against) the proposed action. Typically. In other bond deals and in second lien term loan deals. a single independent collateral trustee for the benefit of the holders of the first and second lien debt. in any restructuring where the second lien creditors are sufficiently organized and able and willing to buyout the first lien position at par. the practice is generally for each of the first and second lien debt holders to have separate collateral agents. an amicable arrangement will likely be within easy reach. 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. How Do Various Classes of Creditors Vote? As we have discussed above. The block vote of each series is determined by a majority of the holders in that particular series. there is some debate as to 15 Number 382 r April 15. 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. 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. As a result. the lien priority and subordination provisions are contained in the collateral trust agreement. if properly documented. Often. Each security document should contain two separate granting clauses and a clear statement of an intention to create two separate classes of secured creditors.Latham & Watkins I Client Alert 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. That agreement will also typically provide for the possibility of future first and second lien financings without a need to amend the documentation. The lien priority and subordination arrangements are governed by an intercreditor agreement signed by the collateral agents for the first and second lien debt. However. Do We Need a Separate Collateral Trustee to Hold the Collateral? In most large second lien bond deals.

Hanrahan. the interest rate on the term loan B generally will be higher than on the term loan A. 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. High yield bondholders have tended to be more accommodating than many term loan lenders. If a credit facility contains both a term loan A and term loan B. or Peter M. 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. Gilhuly. sometimes with specified minimum rates. and typically held by.Latham & Watkins I Client Alert is the popular vote system. Davenport. if any. structuring points that find their way into the lien subordination agreements that define the rights of second lien creditors in these deals. 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. However. in which all of the debt in a class (regardless of series) votes together as a single class. any optional prepayment amounts not applied to prepay the tenn loan B typically will be applied to prepay the term loan A. However. but we have not yet reached a market equilibrium on every point. principal repayment on their tenn loan B's until the maturity date (or the year prior to maturity). Traditional first lien lenders are not predisposed to favor second lien deals. at (213) 891-8485. Marc P. These financings can provide some below-investment-grade companies with access to the capital markets where they would otherwise not have access at all. 2004 . Tenn loan B's bear interest at a floating rate (typically). hedge funds and other institutional investors with a longer term investment strategy. If both a tenn loan A and tenn loan B are made to the borrower in the same transaction. We do not expect first lien lenders to ever be vocal advocates for securing the claims of their junior cousins in the capital structure. at (213) 891-8720 or any of the other Latham lawyers named on the back of this client alert. Tenn loan B's are targeted at. but they can no longer simply ignore these new products. Endnotes 1 Tenn loan B's are a variation on the type of term loans (which are now often called tenn 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. at (212) 906-1284. at (212) 906-2976. tenn loan B lenders generally require only nominal. One series of debt may require majority approval for a particular action. please feel free to call Neil Cummings. we fully expect the market consensus to evolve over time and you should expect that too. As a result. and have the right to refuse all or a specified portion of optional prepayments made by the borrower. If you have any questions about second lien financings or this client alert. 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. but much depends on the context of the particular deal and generalizations are rarely conclusive. Other high yield issuers are able to obtain financing on more favorable terms by granting collateral to their junior creditors. and have covenant packages that are derived from (and substantially similar to) those found in the borrower's traditional Summary Second lien financing structures are here to stay. 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. By lumping all the series of debt into a single voting group. while another series of debt may require supermajority approval for the same action. Second lien bondholders and second lien term lenders are inching their way toward consensus on many of the 16 Number 382 I April 15. there can be costs associated with second lien financing structures. Kirk A.

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. there is a good possibility it will also impair the first liens. if the debtor is denied the use of cash collateral it may be required to cease operations and liquidate. at the auction. second lien term loans and second lien bonds are and will continue to be a part of the portfolios of many CBOs. Nevertheless. Unless the court orders otherwise. such as possession or control. As investors. first lien lenders tend to concentrate their efforts not on seeking to prevent such use. CD Os and CLOs have been incorporating second lien term loans and second lien bonds in their portfolios. in the borrower's high yield bond indenture. ERISA and other statutory liens. in an increasing number of cases.625 more than the total value of their interests in assets of the company pledged to secure those claims. insurance policies and any claims under those policies (other than as proceeds of other collateral). As a practical matter. 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 The UCC covers most types of tangible and intangible personal property. may be entitled to priority over an earlier security interest that is perfected solely by the filing of a financing statement. "gap" claims. certain methods of perfection. generally secured by debt obligations which may include term loans and high yield bonds. including for liens securing purchase money debt and certain tax. CDOs and CLOs are structured vehicles that issue asset-backed securities.Latham & Watkins I Client Alert bank credit agreement or. as discussed in the text accompanying this note. called priority unsecured claims. and employees' wages. CDOs and CLOs. CBOs. called general unsecured claims. 4 their claims against the company is at least $11. Anti-layering covenants are more typically found in bond indentures than in bank loan facilities. reduce dollar for dollar cash price payable by the second lien creditors for the auctioned asset by an amount equal to) to employee • certain types of tax claims. 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. rating agencies and other market players have become more familiar with second lien financings. 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. their treatment in CBOs. the second lien creditors can" creditti. • some types of intellectual property and n • in most states. first lien lenders will often be reluctant to challenge the second liens out of concern that a challenge could boomerang back on them. 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. Any three unsecured or undersecured creditors can commence an involuntary bankruptcy case against a company if the total value of 17 Number 382 ! April is. but will often acquire debt securities in the secondary market within a few days after the initial offering. 10 The exact wording of each anti-layering covenant must be examined carefully to determine whether second lien debt will be permitted. with respect to many types of collateral. The first and second liens tend to be granted under the same set of security documents or under separate but substantively identical security documents. • in an involuntary bankruptcy. all unsecured claims are not treated equally. For tax reasons. these vehicles do not invest in the primary debt offering. 2004 . There are numerous exceptions to this general rule. Certain unsecured claims. CBOs. benefit 11 11 The first lien debt generally does not provide a reciprocal waiver of its right to challenge the second liens. In addition.e. As a practical matter. • certain pre-petition • certain contributions plans. but rather on requiring that such use be conditioned on the debtor's adherence to a tight operating budget. If there is a flaw in the security documents that impairs the second liens. the bankruptcy court will routinely permit use of cash collateral. Under the bankruptcy code. Thus. Some of the significant categories of property not covered by the UCC include: • real estate (other than fixtures). Since 2003. CDOs and CLOs has been evolving and continues to evolve. accountants and other professionals hired by the bankrupt company or certain types of creditors. In the early stages of a case a debtor may have no source of liquidity for operations other than cash collateraL As a result. have the right to be paid in full before any of the residual unsecured claims. are paid.

As discussed in note 10 above. if the series A. In that case.'s application for an exemption from TIA Section 314(d) dated August 8. in most cases. 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. 134 B. motor vehicles (except to the extent those assets are proceeds of other collateral). the series A creditors would be oversecured and the series Band C creditors would be undersecured. If the first liens can be successfully challenged. The case is called In re Ionosphere Clubs. there is a reasonable chance the same case can be made against the second liens. For example. S. In bankruptcy. If a third party makes a cash bid of $120 for one of the bankrupt company's crown jewels. Both the first and second lien debt is secured solely by liens on an asset worth $150.R. Band C creditors each held a separate secured claim. three series (series A. IJ issuers with indentures containing this mechanism have faced extensive SEC comments during the registration process. Credit-bidding allows second lien creditors to lower the cash component of their bid. SEC not favored this fall-away mechanism and those 18 Number 382 I April 15. Band C creclitors held three separate secured claims or were co-owners of a single combined claim. 19 In theory. 528 (Banker. 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. The security agreement contained a single" granting clause" that granted one security interest in favor of the series A. In reality. By creditbidding. the first lien creditors will likely favor the sale because they will get paid off in full. There. 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. However. the entire class. only an oversecured creditor is entitled to post-petition interest. Band C creditors were co-owners of a single combined secured claim. Inc. 2004 . B and C creditors. deposit accounts letter of credit rights as original collateral and. 20 14 L\ Hi 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. A creditor is oversecured if the value of its interest in its collateral exceeds the amount of its claim. including the class A creditors. 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. and there are no other bidders. 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. These and other exceptions from the "blanket lien" are often heavily negotiated and vary from deal to deal. there would have three separate secured claims.Latham & Watkins I Client Alert the value of their interest in the collateral in excess of the value of the first lien creditors' interest in the collateral. which gives them a competitive advantage over other bidders without credit-bid rights. real property (other than fixtures) or any personal property excluded from Article 9 of the UCC. waiving the right to challenge the first liens may not be as big of a concession as it might appear at first blush. HI See the SEC's order granting Allied Waste North America.. The filing of a financing statement does not perfect a security interest in money. The security interest for each of the series A. The issue at stake in the case was whether the series A. Band C creditors were secured by a single security interest. assume that the bankrupt company owes $50 to the first lien creditors and $200 to the second lien creditors. The court stated that. if the three series had been secured by three separate liens on the collateral. Band C) of creditors had a security interest in the same assets of the bankrupt company. If the series A. 1991). Band C creditors were co-owners of a single secured claim because the series A. and certain licenses issued by governmental authorities (such as liquor licenses or FCC licenses). The answer would determine whether the series A creditors were entitled to post-petition interest. 2392). All such decisions were controlled by the first lien creditors.D. would be undersecured. 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. N. 2001 (Trust Indenture Act of 1939 Release No. The bankruptcy court held that the series A. Other common exceptions to a "blanket lien" include one-third of the stock of certain foreign subsidiaries. Inc. Typically.V. Band C creditors was granted in the same security agreement.

but waiver generally expires after 90 to 180 days. Waiver of right to oppose adequate protection for the first lien creditors Typically waived until repayment in full of first lien debt. Consent is typically effective until repayment in full of the first lien debt. Typically waived until repayment in full of first lien debt. Waiver commonly given and remains in effect until repayment in full of first lien debt. in full of first Often waived. their objections may be difficult sustain. enforceability or priority of first liens Waiver commonly given and remains in effect until repayment in full of first lien debt. since What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive in a Bankruptcy? (pages 8-11) concept applies only to secured creditors. but may be a fiercely negotiated point. Advance consent almost never given (even in junior subordinated debt deals). Often waived. Bondholders usually have a "silent second" lien. However. Not applicable." Not applicable. May be fiercely negotiated point. Consent is typically effective until repayment in full of first lien debt. their objections may be difficult to sustain. Unsecured creditors have standing to object to adequate protection for first lien creditors. What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive During the Period Before a Bankruptcy? (page 8) Waiver of right to seek "adequate protection" for second lien debt Typically waived.Latham & Watkins I Client Alert A Snapshot of Market Conditions Provisionllssue In the Second Lien Market (Spring 2004) Secured Term Loan Market Unsecured High Yield Bond Market FAQ and Page Reference Secured High Yield Bond Market Waiver of right to exercise remedies against collateral Typically waived until repayment in full of first lien debt. Unsecured creditors have standing to object to the use of cash collateral. Advance consent usually given. However. since concept applies only to secured creditors. What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive in a Bankruptcy? (pages 8-11) Advance consent to use of cash collateral supported by the first lien creditors Advance consent usually given. 2004 . Waiver rarely given (even in junior subordinated debt deals). given their status as unsecured creditors. What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive in a Bankruptcy? (pages 8-11) 19 Number 382 I April 15. What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive During the Period Before a Bankruptcy Filing? (page 8) Waiver of right to challenge Validity. Unsecured creditors have a right to challenge first liens (or any other liens). Almost never waived (even in junior subordinated debt deals). Significance of this waiver to second lien lenders is greater if the company in bankruptcy has valuable cumbered unenassets. Significance of this waiver to second lien bondholders is greater if the company in bankruptcy has valuable unencumbered assets. Term loan lenders usually have a "quiet second. given their status as unsecured creditors. until repayment lien debt.

but may require that proceeds be applied to permanently reduce first lien debt. waivers would take the same form as for second lien bonds. Consent is typically effective until repayment in full of first lien debt. their objections may be difficult to sustain. Waiver almost never given (even in junior subordinated debt deals). 2004 . What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive in a Bankruptcy? (pages 8-11) Waiver of voting rights on a plan of reorganization Often. Consent is typically effective until repayment in full of first lien debt. Unsecured creditors have standing to object to the terms of any proposed DIP financing. given their status as unsecured creditors. Any waiver will typically be limited to waiver of right to: (1) vote in favor of plan unless it contains specific provisions.Latham & Watkins I Client Alert A Snapshot of Market Conditions Provision/Issue In the Second Lien Market (Spring 2004) (continued) Secured Term Loan Market Secured High Yield Bond Market I Unsecured High Yield Bond Market FAQ and Page Reference Advance consent to any sale of collateral supported by the first lien creditors Advance consent usually given. Advance consent commonly given (if first lien creditors "share the pain"). Generally not waivedwaiver typically very strongly resisted by second lien lenders. Unsecured creditors have a right to vote on a plan of reorganization. Advance consent almost never given (even in junior subordinated debt deals). Advance consent almost never given (even in junior subordinated debt deals). Unsecured creditors have standing to object to sale of any assets (including collateral for second lien debt). However. Consent is typically effective until repayment in full of first lien debt. their objections may be difficult to sustain. Any waiver will often be strongly resisted by the second lien bondholders. Consent is typically effective until repayment in full of first lien debt. Does a 'Silent Second" Lien Creditor Ever End up Worse Off Than an Unsecured Creditor? (pages 11-12) I 20 Number 382 I April 15. not waived at all. given their status as unsecured creditors. If waived. or (2) oppose a plan supported by the first lien creditors. However. Advance consent usually given. What Secured Creditor Rights do the Second Lien Debt Holders Typically Waive in a Bankruptcy? (pages 8-11) Advance consent to DIP financing supported by the first lien creditors Advance consent commonly given (if first lien creditors "share the pain").

Latham & Watkins I Client Alert A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued) Provision/Issue Secured High Yield Bond Market Secured Term Loan Market I Unsecured High Yield Bond Market FAQ and Page Reference Release of second liens outside of bankruptcy Generally. Not applicable since concept applies only to secured creditors. Different deals vary on release of second liens outside of sale context. no collateral can be released unless required term loan lenders agree. automatic release of second liens on any asset sold in accordance with all provisions of the second lien term loan documents. Generally. We have generally only seen automatic releases of second liens as a result of a release of the first liens if the second lien term loans are pari passu with second lien bonds that have this provision and that are being sold concurrently. Who Controls Releases of Collateral Outside of Bankruptcy? (page 12) Release of second liens during bankruptcy Generally. 2004 . Outside of asset sales. generally. Not applicable since concept applies only to secured creditors. second lien bondholders will not object to court-ordered asset sales as long as the second liens attach to the sale proceeds. automatic release of second liens on any asset sold in accordance with the "asset sale" covenant. Term loan agreement may require supermajority and or unanimous approval. Generally. Favored approach gives first lien creditors the" on/off" switch for both first and second liens except where the release is of all or substantially all of the collateral (in which case second lien bondholders must also agree to the release of the second liens). Note favorable TIA results with this approach. Who Controls Releases of Collateral During a Bankruptcy? (page 12) 21 Number 382 I April 15. second lien lenders will not object to court-ordered asset sales as long as the second liens attach to the sale proceeds.

2004 . due to difficulty in getting pledges of stock and intercompany debt and inclusion in many bond deals of a more generous general "basket. but generally will have the same collateral as the first lien creditors.Latham & Watkins I Client Alert A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued) Provision/Issue Secured High Yield Bond Market Secured Term Loan Market Unsecured High Yield Bond Market FAQ and Page Reference Scope of collateral package Endless variations are possible . Do Second Lien Lenders Get the Same Collateral as First Lien Holders? What are the Legal Issues Limiting the Scope of the Collateral Package in Second Lien Bond Deals? What are the Practical Considerations Limiting the Scope of Second Lien Note Collateral? (pages 12-14) 22 Number 382 I April 15.first and second lien debt may have overlapping or completely separate pools of collateral. the second lien bondholders generally will have less collateral than the first lien creditors. If there is significant overlap in collateral. in a registered offering or a 144A offering with registration rights. None." Numerous variations are possible.

Can the Second Lien. all new debt can be incurred and secured subject only to compliance with a minimum fixed charge coverage ratio (typically 2." In subordinated unsecured bond deals.00:1. Cap on first lien debt not applicable to unsecured second lien bonds or term loans. Are There Any Limits on the Amount of Future Second Lieti Debt? (page 14) Option to buyout lien debt at par first Not common. Commonly will be capped based on a maximum leverage ratio or other financial test.00). (In unsecured term loan agreements. Not common.) Are There Any Limits on the Amount of Future First Lien Debt? (page 14) Cap on the amount of second lien debt Commonly will be capped based on a maximum leverage ratio or other financial test.00 or 2. Creditors Purchase the First Lfen Obligations? (pages 14-15) 23 Number 382 I April 15. 2004 . In a senior unsecured bond deal. the amount of secured debt is typically capped at a fixed dollar amount. often the amount of secured debt is capped based on negotiated secured debt "baskets.25:1. and the types of secured debt that can be incurred are generally also restricted. Commonly will be capped at fixed dollar amount (which typically includes a cushion to allow "protective advances") or by reference to maximum leverage ratio or other financial test. Not applicable. See discussion under "Cap on the amount of first lien debt" above.Latham & Watkins I Client Alert A Snapshot of Market Conditions In the Second Lien Market (Spring 2004) (continued) Provision/Issue Secured High Yield Bond Market Secured Term Loan Market I Unsecured High Yield Bond Market FAQ and Page Reference Cap on the amount of first lien debt Commonly will be capped at fixed dollar amount (which typically includes a cushion to allow "protective advances"} or by reference to maximum leverage ratio or other financial test. Some "term loan B" deals have covenants normally associated with high yield bond offerings.

Imrnordino +39 02-85454-11 Moscow Anya Goldin +7-501-785-1234 New Jersey David J. A complete list of our Client Alerts can be found on our Web site at www. please contact Kirk A. Kerman Robert A. Gary M. D.C. Stocks Michael W. Meckler Patrick T. McLean + 1-973-639-1234 New York Michele 0. Marmorstein Tom C.com. Should further analysis or explanation of the subject matter be required. Crumbaugh Donald 1. Neil Cummings or Peter M. O'Neill +1-202-637-2200 24 Number 382 I April 15. Yoshii +81-3-6212-7800 Washington. Gilhuly in our Los Angeles office or any of the following attorneys. Schwartz +1-312-876-7700 Frankfurt Hans-Juergen Luett Uwe Eyles +49-69-60 62 60 00 Hamburg Joachim von Falkenhausen Juergen Huebner +49-40-41 4030 Hong Kong Mitchell D. Hanrahan in our New York office. If you have any questions about this Client Alert. Plaut +1-212-906-1200 Orange County David C. The information contained in this publication should not be construed as legal advice. Epstein Paul J. Singer Scott N. Shapiro Michael J. Penzer Christopher R. Sadler +1-213-485-1234 Milan Michael S. Nelson James Redway +65-6536-1161 Tokyo David 1. Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. Edwards +44-20-7710-1000 Los Angeles Vicki E.Latham & Watkins I Client Alert Office locations: Boston Brussels Chicago Frankfurt Hamburg Hong Kong London Los Angeles Milan Moscow New Jersey New York Northern Virginia Orange County Paris San Diego San Francisco Silicon Valley Singapore Tokyo Washington. Boston Ian B. Sturrock +852-2522-7886 London James Chesterman Bryant B. please contact the attorneys listed below or the attorney whom you normally consult. Edmonson +1-415-391-0600 Silicon Valley Peter F. 2004 . Seaver +1-714-540-1235 Paris Dominique Basdevant Etienne Gentil +33 (0) 1 40 62 20 00 San Diego Andrew D.C. Lynch +32 (0)2 788 60 00 Chicago David G. Hunt William P. Blumenstein +1-617-663-5700 Brussels John P. D. Blohm Tracy K. Wolfe +1-619-236-1234 San Francisco Kenneth E. Koenig + 1-650-328-4600 Singapore Mark A. Davenport or Marc P.lw.

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