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2002Factoring Conference

Subordination 101: All a Factor Ever Wanted to Know

Kenneth M. Greene

Carruthers & Roth, P.A.

235 North Edgeworth Street

Greensboro, North Carolina

336-478-1124

kmg@crlaw.com

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Types of Subordination Generally

• Debt Subordination

• Lien Subordination

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Types of Subordination Generally (Continued)

• Debt Subordination– Establish priorities of payment of debt owing by a common

debtor, whether secured or unsecured debt– Rationale –

• Improve leverage of debtor• Credit enhancement for senior creditor

• Lien Subordination– Establish priorities of liens on assets, regardless of whether

debt is owing by the owner of such assets– As between two secured creditors, liens can be subordinated

without the underlying debt being subordinated

• Both debt and lien subordination are in nature of credit enhancements, so many general concepts applicable to each

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Types of Debt Subordination

• Structural

• Contractual

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Structural Subordination• Typically no contractual agreement between senior creditor

and junior creditor• Debt incurred at different levels within a corporate family• Parent – subsidiary structure is most basic form• Debt issued at parent level is structurally subordinated to

debt issued at subsidiary level since creditors of subsidiary have first claim on assets of subsidiary, while parent’s creditors have claim on parent’s equity in subsidiary

• Rationale – • Improved balance sheet of subsidiary• Debt of parent called senior debt of parent even though subordinated to debt

of subsidiary• In certain cross-border transactions, contractual subordination may not be

recognized

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Structural Subordination (Continued)

• Issues for senior debt holders (generally the lender at subsidiary level)

• Covenants in credit agreement with parent – prohibit restrictions on ability of subsidiary to declare dividends

• Covenants in credit agreement with subsidiary - prohibit dividends to parent or upstream advances to parent

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Contractual Subordination Characteristics of subordinated debt

Promise not to receive payment until senior debt is paid in full

Payment received improperly or in violation of agreement, will be held in trust and paid over to senior creditor

In bankruptcy, dividends on subordinated debt are paid to senior creditor to be applied to senior debt

After senior debt is paid in full, rights to receive dividends reverts to junior creditor

Right of subrogation – after senior debt is paid in full, junior creditor entitled to receive senior creditor’s dividends and junior creditor’s dividends

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A Subordination agreement is enforceable in bankruptcy Section 510(a) of the Bankruptcy Code says that such agreements are enforceable “in a case under this title to the same extent that such agreement is enforceable under applicable non-bankruptcy law”

But, Bankruptcy Code does not define subordination

Contractual Subordination - Continued

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Types of Subordinating Creditors

• Terms and extent of Subordination Agreement are often dictated by type of subordinating creditor

• Institutional high yield debt holder – accepts subordination in exchange for a higher yield

• Corporate insiders (officers, directors)• Sellers in corporate acquisitions that need to provide

seller financing to allow buyer to obtain senior debt financing

• Workouts and restructurings – new money necessary and existing creditors subordinate debt to attract new financing

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Terms of Debt Subordination Agreement

• Terms must be explicit - “subordination of debt” has no meaning; agreement itself establishes terms of subordination

• Courts will construe any ambiguity against drafter of instrument which is usually senior creditor

• Many drafting issues to consider

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Scope and Extent of Senior Debt

• Define Senior Debt as broadly as possible for senior creditor to maintain flexibility and control and avoid further consents– Include other financial products extended by senior creditor

such as cash management services, credit cards, derivative products, foreign currency exchange agreements, equipment financings, letters of credit, etc.

– Include future advances made by senior creditor– Include all amounts now or hereafter owing to senior creditor,

whether under credit agreement or otherwise; limiting to debt under the credit agreement raises issue of amendments and modifications to credit agreement

– Secured or unsecured, fixed or contingent, matured or unmatured

– Resist efforts to cap senior debt as percentage of receivables and inventory – gives junior creditor too much control

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Senior Debt - Continued– Rule of Explicitness

• must mention specifically that senior debt includes post-petition interest at the rate set forth in the credit agreement (including any applicable default rate), whether or not allowed as a claim in a bankruptcy proceeding.

• In absence of such a provision, senior debt will not include post-petition interest that is otherwise not an allowable claim against the debtor – always the case if unsecured senior debt or undersecured debt

– Define senior creditor to include any lender refinancing the debt owing to the original senior creditor

• Sample provision: “Any person or entity whose loans to the Borrower hereafter are used to refinance the Senior Debt shall be deemed for all purposes hereof to be the successor to the Senior Lender, and from and after the date of any such refinancing and satisfaction in full of any Senior Debt, such person or entity shall be deemed a party hereto in the place and stead of the Senior Lender as if such person or entity had been the original signatory hereto.”

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Senior Debt – Continued

– Consider establishing maximum principal amount of senior debt, but negotiate basket for protective advances for preserving or collecting debt.

– Never want to ask junior creditor for consent; to do so opens up renegotiation of subordination terms

– Sample definition -

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Definition of Senior Debt• "Senior Debt" - shall mean all present and future indebtedness

(whether principal, interest (including, without limitation, interest accruing after the commencement of a bankruptcy or insolvency proceeding by or against the Borrower at the rate set forth in the Senior Loan Agreement, including any default rate, whether or not pursuant to applicable law or otherwise the claim for such interest is allowable in such proceeding), fees, collection costs, expenses, liabilities, obligations (including, without limitation, letter of credit reimbursement obligations), and all other amounts of any and every kind now or hereafter owed by the Borrower to the Senior Lender (including, without limitation, all of the indebtedness arising under or pursuant to the Senior Loan Agreement), all whether direct or indirect, absolute or contingent, secured or unsecured, due or to become due, liquidated or unliquidated and all whether arising under contract, in tort, or otherwise.

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Scope and Extent of Junior Debt

• Make as broad as possible consistent with terms of transaction• For institutional subordinated debt holder, generally means

principal, interest and premium on a specific subordinated loan– If combined with equity kicker (usually a warrant), be sure to

subordinate any put provision or mandatory redemption features– If junior debt is seller financing as part of an acquisition, consider

subordinating indemnity payments and other amounts (other than purchase price) owing to seller under acquisition documents

• For insiders, should be not only the specific subordinated loan but also all other indebtedness of any kind present or future– Carve-out for regular salary (permits not a bonus)– Carve-out for lease payments

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Payments of Junior Debt in Bankruptcy• No payments permitted to be made on junior debt in a

bankruptcy or insolvency proceeding – most common form of subordination

• In bankruptcy or other kind of insolvency proceedings, senior creditor entitled to be paid in full before junior creditor can receive any payment on junior debt

• Exception for permitted junior securities – junior creditor can keep these if are equity securities or if debt securities subordinated to same extent as the junior debt– Sample provision:“(excluding securities provided for by a plan of

reorganization or readjustment that are equity securities or are subordinated in right of payment to all indebtedness issued to the Senior Lender in such plan of reorganization or readjustment to substantially the same extent as, or to a greater extent than, the Subordinated Debt is subordinated to the Senior Debt as provided in this Agreement)”

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Permitted Payments on Junior Debt Outside of Bankruptcy

• Absolute payment bar • No payments of any kind may be made without

consent of senior creditor• Alternatively, is senior creditor going to allow

any kind of payments to be made on junior debt outside of a bankruptcy or insolvency proceeding, and, if so, what kind of payments and under what circumstances?

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Limited Payment Bar

– Some payments may be made under certain circumstances

– May be just interest or both principal and interest

– May be an amount of principal that meets some kinds of financial tests

• availability both before and after payment; use an averaging method and not a snapshot on a single day

• trailing excess cash flow

• pro forma debt service ratio

• Sample provision:

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Financial Test for Permitted Payment

The Borrower may pay to the Junior Lender, and the Junior Lender may demand, accept and retain from the Borrower, the following payments on the Junior Debt and no other payments:

(i) periodic payments of interest accruing on the Junior Debt, as and when the same become due and payable under the terms of the Junior Debt;  

(ii) payments of principal made from time to time by the Borrower on the Junior Debt, provided each of the following conditions shall have first been satisfied: (A) the Borrower or the Junior Lender on behalf of the Borrower shall have given the Senior Lender not less than five (5) Business Days written notice of the Borrower's intention to make such principal payment and the scheduled payment date (a "Principal Payment Date"), and (B) the amount of such principal payment to be made on a Principal Payment Date shall not exceed the amount by which Average Daily Availability for the Calculation Period exceeds $1.5 million. 

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Types of Default in Senior Debt

– With subordination agreements that permit some limited payments outside of bankruptcy, usually the agreement will prohibit the making of any further payments upon the occurrence of some triggering event

– Generally a default in the senior debt will trigger blockage of all payments on junior debt

– May be just a payment default that blocks payment on junior debt

– May be a payment default and all other kinds of default that blocks payment on junior debt – all non-monetary defaults, including financial covenant defaults

– May be a payment default and any “material” non-payment default that blocks payment on junior debt – that is payment default and breach of a financial covenant

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Blockage of Payment Provisions

• Blockage of payments may be automatic upon happening of triggering event or only upon receipt by junior creditor of a “payment blockage notice” from senior lender

• Sample provision:– “Upon the occurrence of a Senior Lender Default and the giving of written

notice thereof by the Senior Lender to the Junior Lender (a "Payment Default Blockage Notice"), then no payment or distribution of any assets of the Borrower of any kind or character, whether in cash or property, by setoff or otherwise, other than Permitted Junior Securities, shall be made on account of Junior Debt, unless and until such Senior Lender Default giving rise to such Payment Default Blockage Notice shall have been cured or waived in writing or shall have ceased to exist or all Senior Debt shall have been discharged or paid in full.”

• Number and duration of payment blockage notices may be limited by negotiation

• Generally, no limit on number or duration of any payment blockage notices for payment defaults on senior debt

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Blockage of Payment Provisions -Continued

• Common for duration of each payment blockage period and the number of payment blockage notices that can be given on account of non-monetary defaults on senior debt to be limited

• Generally payment blockage period limited to a fixed duration (usually no more than 179 days to correspond to no more than two semi-annual installments of interest on junior debt) – at least with public subordinated debt

• If the senior debt is not accelerated on account of the non-monetary default before end of payment blockage period, the payment block lapses and the junior creditor may continue to be paid

• If the senior debt is accelerated on account of the non-monetary default before the end of the payment blockage period, that would trigger payment default for which payment block would be reinstituted (if any required notice is given) on account of a payment default not a non-monetary default

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Blockage of Payment Provisions -Continued

• Limit to number of payment blockage notices senior lender may send during a specific period– norm seems to be no more than three payment blockage notices for non-

monetary defaults over a period of 365 consecutive days– known defaults at time of sending one payment blockage notice cannot

be the subject of a future blockage notice – must combine all at one time– May be required interval before sending another payment blockage

notice on account on non-monetary default

• Successful payment blockage does not prevent a default on junior debt from occurring; junior creditor can pursue remedies (e.g, acceleration, suit for judgment, etc.) unless remedies standstill in effect– Important for senior creditor to review and approve covenants in junior

debt instruments and to eliminate cross-default provision that would default junior debt upon default of senior debt

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Standstill of Remedies – Remedies Block• A remedies block bars enforcement of any remedy by the junior

creditor to collect the junior debt – including filing of involuntary bankruptcy case

• Junior creditor is not only prohibited from receiving payments on junior debt but also cannot accelerate and file suit to collect junior debt

• Permits a restructuring of the senior debt without interference by junior creditor – frozen out of workout room

• All limitations on payment block equally applicable to remedies block (duration, number of blocks)

• Remedies block may be shorter than payment block– Even if junior creditor can exercise remedies, must turnover any payments to

senior lender if payment block still in effect– Just permits junior creditor to exercise remedies and not be frozen out of

process forever • Usual exceptions to remedies block if senior debt is accelerated or

bankruptcy occurs

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Double Dividend System and Subrogation

• All dividends payable on junior debt are assigned to senior creditor for application to senior debt until senior debt is paid in full

• Senior creditor gets double dividend – in addition to getting usual dividends on its own senior debt, senior creditor gets dividends on junior debt

• If double dividend right is important to senior creditor, may want to prohibit any conversion of junior debt to equity or any forgiveness of junior debt

• Since junior creditor gives its dividend to senior creditor, junior creditor wants right to receive double dividends after senior creditor is paid in full – the right of subrogation

• Subrogation allows junior creditor to step in shoes of senior creditor• Subrogation should only be after senior debt paid in full• Subrogation should only be to extent that payments on junior debt are

instead paid to senior creditor

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Subrogation - Continued• A sample subrogation provision:• “After all of the Senior Debt has been paid in full and

until all of the Subordinated Debt has been paid in full, the Subordinated Lender shall be subrogated to the rights of the Senior Lender to receive payments and distributions of assets with respect to the Senior Debt, to the extent that distributions otherwise payable to the Subordinated Lender have been applied to the payment of Senior Debt in accordance with the provisions of this Agreement.”

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Subrogation Example• Chapter 11 plan provides for 50% dividend on all claims payable in

ten equal consecutive monthly installments• Senior debt is in amount of $200 so its total dividend is $100; and

junior debt is in amount of $1,000 so its total dividend is $500.• Junior debt monthly dividend is $50 ($500 divided by 10); and senior

debt monthly dividend is $10 ($100 divided by 10).• All Junior debt dividends are paid to senior creditor; after four months

senior debt claim of $200 is paid in full. It has received on its own claim $10 X 4 or $40 and on the junior claim $160 (consisting of the first three installments of $50 each and $10 on the fourth installment)

• If Junior creditor only gets dividend on balance of its own claim, it would recover only $340 ($500 minus $160 already received by senior creditor)

• By subrogation on remaining balance of Senior Debt, junior creditor also gets the remaining balance of Senior Debt of $60, for a total distribution to junior creditor of $400 ($340 on the Junior Debt and $60 on the Senior Debt)

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Subrogation - Continued

• To protect right to double dividends, senior creditor should also prohibit any further subordination of the junior debt

• A second senior creditor dilutes the amount of the double dividend received by the senior creditor

• An example of the mischief caused by a second subordination of the same junior debt– Debtor’s assets liquidate in bankruptcy for $600,000– Senior Debt is $500,000; junior debt is $500,000; and second senior

creditor’s claim is $500,000; total of all claims is $1.5 million for a 40% dividend to creditors ($600,000 divided by $1.5 million)

– If distribution is made on “first in time, first in right” theory, then original senior creditor gets $200,000 on its own senior debt claim and $200,000 on the junior debt claim for a total of $400,000.

– If distribution is made on basis that both senior creditors have an equal claim to the junior creditor’s dividend, then original senior creditor gets $200,000 on its own senior debt claim and only $100,000 on the junior debt claim for a total of $300,000 – the second senior creditor gets the other $100,000 on the junior debt claim

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Rights of Senior Creditor to Act for Junior Creditor

• Important to protect senior creditor’s right to the double dividend that it be able to exercise certain rights of junior creditor in bankruptcy proceeding of borrower

• Senior creditor must be able to file proof of claim for the junior debt to insure dividend on the junior debt– Bankruptcy Rule 3001 grants a creditor’s agent the right to file claim in

creditor’s name• Senior creditor may also want to vote the junior debt proof of claim

– Prevent junior creditor from blocking plan favorable to senior creditor– Increase leverage of senior creditor in negotiations concerning the

amount of the payment it is to receive under the plan– Bankruptcy Code says that only the “holder” of a claim may vote it. Is

the the senior creditor the holder of that claim for purposes of voting?

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Miscellaneous Other Protective Provisions

• Assignment of Junior Debt– Transfer of junior debt to a person for value and without notice

of subordination may result in the transferee taking the junior debt free of the subordination

– Require instrument legend• “The Subordinated Notes, and any other instruments (and all

replacements thereof) which at any time evidence the Subordinated Debt or any part thereof, shall be inscribed with a legend conspicuously indicating that the payment and enforcement of the Subordinated Debt is subordinated to the claims of the Senior Lender pursuant to the terms of this Agreement and copies thereof shall be delivered to the Agent promptly thereafter.”

– Require transferee to sign separate agreement at time of transfer acknowledging that transfer is being made subject to terms of subordination agreement

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Assignment of Junior Debt

– A sample provision: – “The Subordinated Lender agrees that until all of the

Senior Debt has been paid in full, the Subordinated Lender will not assign, transfer or otherwise dispose of the Subordinated Debt or any portion thereof unless such assignment, transfer or other disposition is made expressly subject to this Agreement, and the assignee or transferee expressly acknowledges in an instrument delivered to the Senior Lender that the Subordinated Debt is being assigned or transferred subject to the terms of this Agreement.”

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Alteration, Increase or Amendment of Senior Debt

– Subordination is similar to a contract of guaranty in that junior creditor assures payment of senior debt to extent of value of junior debt

– Subordinating party deemed to be a surety and and junior creditor deemed to be released from subordination if unauthorized actions taken by senior creditor that increase junior creditor’s risk -- same as guaranty – so need contractual waivers

– Sample waivers:

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WaiversThe Senior Lender may, at any time and from time to time, without the consent of or notice to the Subordinated Lender, without incurring responsibility to the Subordinated Lender and without impairing or releasing the subordination provided hereunder or the obligations of the Subordinated Lender hereunder, do any one or more of the following:

(i) Amend, modify, waive or consent to any term or provision set forth in any of the Senior Lenders Documents;

(ii) Change the manner, place or terms of payment or extend the time of payment of, or refund or refinance, or renew or alter, any of the Senior Debt;

(iii) Sell, exchange, release or otherwise deal with any property pledged, mortgaged or otherwise securing all or any portion of the Senior Debt;

(iv) Release any Person liable in any manner for the payment or collection of any of the Senior Debt;

(v) Exercise or refrain from exercising any rights against the Borrower or any other Person; and

(vi) Take any other action which might otherwise constitute a defense available to, or a discharge of, the Subordinated Lender in respect of its obligations under this Agreement.

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Negative Covenants of Junior Creditor

• Not change terms of payment of junior debt or amend any of the provisions of the junior debt documents

• Not accept any security for the payment of the junior debt

• Not accept any prepayments on the junior debt

• Not challenge the validity or enforceability of the senior debt or any liens securing the senior debt

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Disgorgement of Senior Debt – Reinstatement

• What happens if senior debt is paid down before a bankruptcy case, but then trustee avoids payment as a preference?

• Senior lender pays back preferential payment to trustee and the amount of the senior debt is increased to original amount – is this increased amount part of the senior debt?

• Sample provision:• “The provisions of this Agreement shall continue to be effective

or be reinstated, as the case may be, if at any time payment of any Senior Debt is rescinded or must otherwise be returned by any of the Senior Lenders upon the insolvency, bankruptcy or reorganization of the Borrower, or otherwise, all as though such payment had not been made.”

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Senior Debt Incurred in Bankruptcy

• Issue -- Does Senior Debt include post-petition financing in a bankruptcy proceeding?

• Generally, filing of a bankruptcy case creates a new and distinct legal entity and the debtor in a bankruptcy case is a different entity than the pre-petition borrower

• Insert contractual provision – In any bankruptcy case of the Borrower, the Senior Lender may

provide cash collateral or other financing to the Borrower under Sections 363 or 364 of the Bankruptcy Code, and, in the case of any such financing pursuant to Section 364 of the Bankruptcy Code, all such financing shall constitute Senior Debt.”

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Right to Terminate• Normally subordination agreement remains in effect until Senior

Debt is paid in full• Junior Lender may insist upon right to terminate subordination

agreement and not subordinate as to Senior Debt made after its giving of written notice of termination to Senior Lender

• Such a termination provision grants the Junior Lender the right to determine when a liquidation will commence – the Senior Lender, upon receipt of notice, must stop funding or risk the loss of the benfit of the debt subordination for future advances

• If include such a provision, – Provide sufficient prior written notice to give opportunity to remedy situtation– make sure that giving of such notice of termination is default under senior loan

agreement or right to terminate commitment to extend credit– Any termination is merely prospective and will not effect subordination as to

senior debt in existence on effective date of termination

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Lien Subordination Generally• Consensual agreement by two or more secured creditors to

detail the relative priority of their security interests in the assets of a common debtor

• Its purpose is to order (or re-order) priorities and create certainty regarding the exercise of rights and remedies of the competing secured creditors

• It is not a security agreement, and does not create a security interest, but merely establishes the relative priority of the security interests of the parties to the agreement

• Lien subordination agreement is not a debt subordination agreement; it does not affect the creditor’s right to receive payment of the secured debt or restrict enforcement of creditor’s claim against the debtor

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Statutory Basis for Lien Subordination

– §1-102 of UCC: “The effect of provisions of this chapter may be varied by agreement . . . except that the obligations of good faith, diligence, reasonableness and care . . . may not be disclaimed by agreement”.

– §9-339 of UCC: “This Article does not preclude subordination by agreement by a person entitled to priority.”

– As quoted before, §510(a) of the Bankruptcy Code provides that a subordination agreement is enforceable in bankruptcy.

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Selected Issues To Be Addressed in Lien Subordination Agreement

• Contractual Agreement as to Lien Priority– Explicit statement as to priority of liens

notwithstanding the time, order, manner or method of creation, perfection and priority of the respective security interests

– Make specific the assets that are subject to the subordination agreement

– Include future assets

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Limitations on Enforcement of Remedies

• Generally, senior lienholder will want to limit or totally prohibit the junior lienholder’s right to exercise any remedies against the common collateral– “The Junior Creditor shall have no right to take any action

with respect to the Senior Creditor Collateral, whether by judicial or non-judicial foreclosure, notification to the Borrower's account debtors, the seeking of the appointment of a receiver for any portion of the Borrower's property or assets or otherwise, or to take possession of any of the Senior Creditor Collateral, unless and until all of the Senior Creditor Indebtedness shall have been fully, finally and indefeasibly paid in cash and the Senior Creditor Documents terminated in writing.”

• Also want to limit or restrict rights of junior lienholder in bankruptcy since junior lien impedes post-petition financing including consensual use of cash collateral

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Lien Subordination - Bankruptcy• Sample provision:• “If the Borrower shall become subject to a proceeding under the

Bankruptcy Code, and if the Senior Lender shall desire to permit the use of cash collateral by the Borrower or to provide post-petition financing from the Senior Lender to the Borrower, the Junior Lender agrees that –(a) adequate notice to the Junior Lender shall be deemed to have been provided for such use of cash collateral or such post-petition financing if the Junior Lender receives notice thereof at least three (3) business days prior to the earlier of (i) any hearing on a request to approve such use of cash collateral or such post-petition financing or (ii) the date of entry of an order approving the same; and –(b) no objection will be raised by the Junior Lender to any such use of cash collateral or such post-petition financing from the Senior Lender on the grounds of a failure to provide adequate protection for the Junior Lenders' junior lien, provided that the Junior Lender is granted a comparable junior lien on the post-petition collateral of the Borrower. No objection will be raised by the Junior Lender to the Senior Lender's motion for relief from automatic stay in any such proceeding to foreclose on, sell or otherwise realize upon the Senior Lender Collateral.”

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No Challenge of Senior Lien by Junior Lienholder

• Junior lienholder cannot challenge or contest the validity or perfection of the senior lien– Non-perfection by reason of documentation defect

– Fraudulent conveyance

– Equitable subordination

• Particularly important when debt is not subordinated and if lien priorities are reversed, junior lienholder will be elevated to first priority position and get proceeds of collateral

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Marshalling

• Equitable doctrine of marshalling arises when junior lienholder has lien in some but not all of the same assets of a debtor which secure the debt owing to senior lienholder

• Example--–Lender 1 has first lien in all assets of debtor, including real estate–Lender 2 has second lien in only accounts and inventory–When Lender 1 goes to foreclose lien, Lender 2 will argue that Lender 1 should proceed first to recover debt from real estate in order to enhance equity in accounts and inventory for benefit of Lender 2–If Lender 1 proceeds first against accounts and inventory, would leave little or any remaining collateral for Lender 2–So Lender 2 argues that Lender 1 should marshall its collateral for benefit of Lender 2 and proceed first against the real estate—obviously something Lender 1 does not want to do

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Marshalling - Continued

• Contractual waiver of marshalling clause is enforceable

• Sample provision:– “The Junior Lender waives any right to require the

Senior Lender to marshal the Collateral for the Senior Debt or otherwise to compel the Senior Lender to seek recourse against or satisfaction of the Senior Debt from one source before seeking recourse or satisfaction from the Collateral or any other source.”

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Release of Collateral by the Junior Lienholder

• Senior lienholder will want junior lienholder to automatically release lien in the collateral if senior lienholder releases it lien

• Particularly important in workout/liquidation when senior lienholder is liquidating collateral for prices it deems adequate and junior lienholder does not agree with price

• The trade off is for senior lienholder to agree to apply proceeds to reduce senior debt and thereby increase equity in assets for benefit of junior lienholder

• Sample provision:

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Release of Lien Provision

“The Junior Lender agrees, whether or not a default has occurred under the Junior Debt, to release or otherwise terminate its Lien in all or any portion of the Collateral upon written request of the Borrower or the Senior Lender to the extent necessary to permit all or portion of the Collateral to be sold or otherwise disposed of by the Borrower or the Senior Lender, whether or not in the ordinary course of the Borrower's business; provided, however, that substantially contemporaneously with such release or termination, the proceeds of such sale or disposition (net of reasonable sales expenses and customary closing costs which are required to be paid as a condition of the sale and which the Senior Lender permits to be paid) are applied to the Senior Debt.”

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Insurance Provisions• Secured creditors may both have interests in casualty or credit

insurance insuring the common collateral

• Common to include provisions treating insurance just like any other proceeds of collateral and having same priorities

• But senior lienholder generally also wants to preserve for itself the exclusive right to adjust, settle or enforce the insurance policies

• Sample provision:– “Each Lender agrees that the other Lender shall be entitled to obtain loss

payee endorsements and/or additional insured status with respect to any and all policies of insurance now or hereafter obtained by the Borrower insuring casualty or other loss to any of the Collateral. The Sender Lender shall have the sole and exclusive right to adjust or enforce settlement of insurance claims in the event of any covered theft, destruction, casualty or other loss to such Collateral. All proceeds of such insurance shall be payable to the Senior Lender. The Junior Lender shall cooperate, if necessary, with the Senior Lender in effecting payment by the insurer to the Senior Lender.”

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Effect of Non-Perfection of Senior Lienholder’s Lien

• Facts:– Lender 1 has perfected lien in all of debtor’s assets– Lender 2 wants to make loan to debtor secured by

portion of debtor’s assets consisting of equipment– Lender 1, to accommodate Lender 2’s loan,

subordinates its lien in debtor’s equipment.– Debtor files bankruptcy and its bankruptcy trustee

discovers that Lender 2 does not have a perfected lien in equipment.

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Arguments and Strategy of Trustee

• Trustee will try to avoid Lender 2’s senior lien under §544 (strong arm powers of the trustee) of Bankruptcy Code and then preserve lien for the benefit of the bankruptcy estate

• Statutory authority - §551 of the Bankruptcy Code provides that any transfer avoided under §544 is “preserved for the benefit of the estate”

• Under that statute, estate can also preserve benefit of subordination agreement by which Lender 1 agreed to subordinate its lien in the first place

• Lender 1 is not harmed – it contractually subordinated its lien and trustee is only enforcing agreement against Lender 1

• Since estate then has benefit of Lender 2’s avoided first lien and the benefit of Lender 1’s contractual agreement, the estate receives the first monies from the sale of the equipment to the extent of the amount of that lien.

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Arguments of Lender 1

• Legislative history of statute indicates that trustee is not entitled to assert priorities and rights of secured creditors

• Subordination agreement is only between two lenders and trustee is not a beneficiary of that agreement

• In absence of subordination agreement Lender 1 would have won anyway; since it is perfected, why should it be penalized by Lender 2’s mistake

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Drafting Solutions• Subordination by Lender 1 is conditioned upon

existence of perfected, unavoidable security interest of Lender 2

• If Lender 2’s lien is unperfected or avoided for any reason, subordination is null and void

• Sample provision:– “The subordination and priorities specified herein are

expressly conditioned upon the nonavoidability and perfection of the security interest to which another security interest is subordinated and, if the security interest to which another security interest is subordinated is not perfected or is avoidable for any reason, then the subordination and relative priority agreements provided for herein shall not be effective as to the particular collateral which is the subject of the unperfected or avoidable security interest.”

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Another Drafting Tip

• Make subordination agreement for the benefit of the two lenders only and not for the benefit of the borrower, any guarantor or any third party

• Sample provision:– “All of the understandings, agreements, representations and

warranties contained in this Agreement are solely for the benefit of Lender 1 and Lender 2 and there are no other parties (including the Borrower) who are intended to be benefited in any way whatsoever by the provisions of this Agreement.”

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Circuity of Lien Problem

• Facts:– Lender 1, Lender 2 and Lender 3 all have liens on the

debtor’s equipment in that priority

– Lender 1 agrees to subordinate its lien to Lender 3

– Lender 2 does not enter into subordination agreement

– In debtor’s bankruptcy, how do equipments proceeds get distributed?

– Circular liens: lender 1 senior to lender 2; lender 2 senior to lender 3; and lender 3 senior to lender 1

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Arguments of Lenders

• Lender 2 says that it has first lien because it is senior to Lender 3 and Lender 1 has subordinated its lien to Lender 3

• Lender 3 says that to elevate Lender 2 is to give Lender 2 a windfall; Lender 2 had nothing to do with subordination agreement and Lender 3 should get benefit of its bargain, namely, the benefit of Lender 1’s first lien

• Cases are in conflict, but majority favor Lender 3 on a limited basis

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Majority Rule• Set aside from proceeds of sale amount of Lender 1’s lien• From that amount, pay claim of Lender 3 and any balance is

used to pay Lender 1• After amount of Lender 1’s claim is distributed between

Lender 3 and Lender 1, pay Lender 2 in full• If any balance remains after Lender 1’s claim has been set

aside and Lender 2 paid in full, distribute remaining balance first to Lender 3 and after Lender 3 paid in full, then to Lender 1

• Result neither burdens or benefits Lender 2; Lender 2 is neither benefited nor prejudiced by subordination agreement

• Practice tip – look for hidden or intervening liens to avoid issue in the first place

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Notices• Common for one lienholder to ask other lienholder

to give notice of default, acceleration, foreclosure, etc.

• May have cross-default or cross-acceleration provision in security agreement

• If one lienholder proceeding against collateral, any other lienholder also wants to proceed against collateral

• But do want administrative error in neglecting to send notice to be grounds to set aside contractural priorities of liens established in the lien subordination agreement

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Notices - Continued• Sample Provision –

– Senior Creditor agrees to give to the Junior Creditor notice of default, termination, demand, acceleration, exercise of remedies and any other notice which is of a like nature or required to be given under the Senior Creditor Documents or by law, and the Junior Creditor agrees to give the Senior Creditor notice of any default, termination, demand, acceleration, exercise of remedies and any other notice which is of a like nature or required to be given under the the Junior Creditor Documents or by law, in each case concurrently with the giving of such notice to the Borrower; provided, however, that no failure of either party to give such notice shall affect the relative priorities of the liens and security interests established in this Agreement.

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Assignment of Liens• Is a lien subordination agreement binding upon an

assignee of the subordinated lien who buys the lien and the debt secured thereby without notice of the subordination?

• Same issue as with debt subordination when suggested that put conspicious legend on note stating that the debt evidenced by the note is subordinated pursuant to the debt subordination agreement.

• Require subordinating creditor to file amendment to its financing statement stating that the lien in the collateral described in the financing statement has been subordinated to the lien of the senior creditor

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Waivers by Subordinated Creditor• UCC requires any foreclosure sale to be commercially

reasonable– UCC §9-610(b) states that “every aspect of a disposition of

collateral, including the method, manner, time, place, and other terms, must be commercially reasonable”.

• Debtor may not waive its entitlement to a commercially reasonable disposition of collateral by secured party– UCC §9-602 specifically prohibits “debtor” or “obligor” from

waiving rights under §9-610(b) to insist upon a commercially reasonable sale of collateral

• But a junior lienholder is neither a “debtor” nor an “obligor” as those terms are defined in the UCC and can therefore waive the right to insist upon a commercially reasonable sale

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Waivers by Subordinating Creditor - Continued

• Junior creditor can also agree not to assert any claims against senior creditor for its actions in disposing of the collateral – important particularly when have standstill by junior lienholder

• Sample Provision -- The Junior Creditor specifically and irrevocably waives any right it may have against the Senior Lender, whether at law or in equity, including rights under the Uniform Commercial Code, and, specifically, any right to assert any claim or bring any action, suit or proceeding, whether at law or in equity (“Action’) against the Senior Creditor or raise any affirmative defense, claim or counterclaim (“Defense”) in any Action brought against it by the Senior Creditor, the effect of which is to contest the commercial reasonableness of the decisions or actions of the Senior Creditor (whether made or taken alone or through any of its agents) with respect to the Collateral, and the Junior Creditor explicitly and irrevocably covenants with the Senior Creditor that the Junior Creditor shall forever and for all time forbear from bringing any such Action or asserting any such Defense against the Senior Creditor.