Silence Is Golden: Second Lien Creditor Rights Post-Momentive

November 12, 2014

On October 14, 2014, the Bankruptcy Court for the Southern District of New York issued a bench ruling (as later modified, the “Bench Ruling“) in the In re MPM Silicones, LLC (“Momentive“) Chapter 11 cases (Case No. 14-22503-rdd, Adv. Proc. Nos. 14-08248 [Docket No. 50], 14-08247 [Docket No. 60]), which serves as a stark reminder of the function and importance of carefully drafted and negotiated intercreditor agreements in a Chapter 11 context.  Intercreditor agreements generally govern the rights of multiple classes of creditors vis à vis each other.  A typical intercreditor agreement directs future distributions post-default by the issuer and defines subject creditors’ ability to participate in both future enforcement actions against collateral and financial restructurings of the issuer.  The Bench Ruling underscores the adverse consequences to senior creditors if they do not negotiate for broad protections that anticipate collateral enforcement and financial restructurings, including Chapter 11 outcomes.

Facts:

The Momentive debtors filed for Chapter 11 relief on April 13, 2014.  Prior to filing, the company entered into a restructuring support agreement with certain holders of the debtors’ second lien notes (the “RSA“), which RSA formed the foundation for the debtors’ plan of reorganization (the “Plan“).  On June 23, 2014, over first lien creditor objections, the Court approved the Momentive debtors’ assumption of the RSA.[1]

Trustees for the two classes of Momentive first lien debt filed complaints against second lien creditors and the second lien trustee in a New York Supreme Court (as subsequently removed to the Bankruptcy Court, the “Intercreditor Actions“), asserting violations of the Momentive intercreditor agreement (the “ICA“).  Senior creditors alleged that second lien creditors’ execution of the RSA and performance thereunder created three separate ICA breaches:  first, by allegedly contesting first lien creditor requests for adequate protection; second, by intervening in an adversary proceeding commenced by the debtors to contest the first lien creditors’ asserted make-whole claims; and third, by supporting the company’s Plan itself.[2]  The final objection centered, in large part, on the Plan’s treatment of Momentive‘s secured debt.[3]  On the Plan effective date, second lien creditors received the reorganized Momentive debtors’ equity.  By contrast, the Plan offered first lien creditors a choice.  If the classes of first lien claims voted in favor of the Plan, first lien creditors would receive cash equal to the full amount of their claims, excluding any amounts recoverable as a make-whole premium or breach claim under the first lien loan documentation.  Conversely, if either class voted to reject the Plan, first lien creditors in that class would receive replacement notes with a present value equal to their full first lien claim, but reserve the right to litigate the claim amount.[4]  The proposed first lien treatment, thus, sought to compel first lien creditors to forgo a breach or make-whole claim as part of a consensual confirmation process.  Ultimately, both classes of first lien creditors overwhelmingly voted to reject the Plan, prompting a confirmation battle over the first lien claim amount and the terms of the replacement notes.

First lien creditors sought support for their breach allegations in various ICA provisions, certain of which directly curtailed second lien creditor action in an insolvency context.  Specifically, first lien creditors alleged that execution of the RSA (obligating second lien creditors to support the debtors’ post-petition financing) breached the ICA’s prohibition against section lien creditors’ contesting any first lien request for adequate protection.  Similarly, first lien creditors asserted the second lien creditors’ support for the Momentive debtors’ cram-down Plan violated ICA restrictions on second lien creditors’ receipt of collateral or proceeds thereof prior to the payment of all first lien obligations in full in cash.  Finally, first lien creditors asserted that the junior creditors’ intervention in the make-whole litigation generally constituted an “action that would hinder any exercise of remedies” by first lien creditors in violation of the ICA.[5]  No ICA provision directly prohibited claim objections.

Second lien creditors contested each allegation, and in particular, argued that their actions were consistent with their rights as unsecured creditors, rights preserved under the ICA “[n]otwithstanding anything to the contrary in [the agreement].”[6]

The Intercreditor Actions were dismissed by the Bench Ruling.

The Ruling:

The Momentive Court’s analysis of the ICA’s overarching purpose heavily informed its dismissal of the Intercreditor Actions.  The Court found that the ICA primarily served to define “parties’ rights in respect of shared collateral.”[7] In reaching this conclusion, the Court highlighted the second lien creditors’ broad retention of unsecured creditors’ rights and remedies against the Momentive debtors.  As the actions taken by the second lien creditors did not directly pertain to the senior creditors’ interest in shared collateral or any right “very clearly precluded or constrained” by the ICA, the Court refused to find the existence of contractual breach.[8]

The Momentive Court’s analysis of the second lien creditors’ intervention in the make-whole claim litigation illustrates the Court’s treatment of the parties’ relative rights under the ICA and its strict reading of the language of that document.  The ICA did not expressly prohibit second lien creditors from contesting the first lien asserted claim, and the Court rejected the argument that the second lien creditors’ intervention in the make-whole litigation could be construed as an attempt to hinder senior creditors’ ability to exercise their rights in violation of the ICA.[9]  In short, the Court declined to read into ICA provisions governing the parties’ respective rights as to collateral any restriction on junior creditors’ contesting the senior creditors’ asserted claim.[10]  Absent a specific and applicable prohibition, the ICA “must be read to give the [second lien creditors] the unfettered right to act as unsecured creditors to object to the senior lien holders’ claims.”[11]

The Court employed a similar analysis when evaluating arguments about subordinated creditors’ entry into the RSA and related support for the DIP financing and the Plan.  Again, the Court started from the basic proposition that second lien creditors, as holders of a substantial unsecured deficiency claim, retained their right to take any position unless expressly constrained by the ICA.  The ICA prohibited second lien creditors from objecting to DIP financing supported by first lien creditors and contesting any first lien creditor request for adequate protection.[12]  There was, however, no correlative restriction against second lien creditors either providing their own financing or supporting a financing provided by a third party, nor was there evidence on the record of second lien creditors’ having taken any position with regard to first lien adequate protection.  Finally, the ICA failed to establish any restriction regarding plan confirmation.  As a result, the debtors and the second lien creditors were free to enter into the RSA, notwithstanding its relation to the priming DIP financing or cram-down Plan.  Under the facts at issue, the Momentive second lien creditors, while taking actions adverse to first lien creditors’ interests, were simply exercising their rights as unsecured creditors, and these rights did “not conflict with any more specific provision in the ICA in a way that might create any contextual ambiguity.”[13]

Takeaways:

An intercreditor agreement seeks to allocate risk between the subject creditor classes.  Each intercreditor negotiation and, therefore, each intercreditor agreement represents a distinct series of compromises.  Indeed, the American Bar Association’s model First Lien/Second Lien Intercreditor Agreement (the “Model Intercreditor“)[14] is not so much a form agreement as it is a set of sample provisions to be selected based on the outcome of expected intercreditor negotiations.

Intercreditor negotiations reflect, among other things, the tension between two conflicting forces in the loan origination market.  On one hand, senior creditors have an incentive to negotiate for the greatest number of protections available.  On the other hand, the same senior creditors generally benefit from a robust second lien loan market (which offers issuers greater liquidity and senior creditors downside protection in a default scenario).  A general shift towards greater senior creditor protections could impair that market.  Lenders may be less willing to advance capital on a junior basis if they must remain completely “silent” in a future restructuring.  Yet a further complication is that the creditors that originally negotiate these arrangements may not be attentive to the same considerations as the creditors who might buy the paper in a default scenario.

The Bench Ruling’s interpretation of the ICA underscores the importance of intercreditor negotiations at loan origination.  In the future, senior creditors would be well advised to demand specific and far-reaching protections that cover more than pure collateral enforcement.  Indeed, Momentive could negatively impact the trading prices of first lien debt which lacks appropriate first lien intercreditor protections.  Post-Momentive, the following intercreditor points may all be the subject of increased focus and negotiation:

• Insolvency Protections:  Intercreditor agreements will be strictly construed in bankruptcy.  Unless junior creditors expressly contract away a right, a bankruptcy court following Momentive is unlikely to read the waiver into an intercreditor agreement.  The burden, therefore, rests with senior creditors to negotiate and contract for broader Chapter 11 protections which prohibit junior creditors from taking positions in opposition to senior creditors’ interests.  The Momentive ICA, by contrast, failed to adequately address key aspects of the Chapter 11 process in which the interests of first and second lien holders are often not aligned.  For example, the ICA provided no guidance regarding plan confirmation and obligated second lien creditors only to refrain from objecting to a DIP financing supported by first lien creditors.  The ICA was silent on what would happen if the first lien creditors did not support the proposed DIP financing as was the case in Momentive.  Similarly, unlike some intercreditor agreements, the ICA did not bind junior creditors to oppose an asset sale not supported by senior lenders.  The ICA adopted a narrower standard giving senior creditors the “exclusive right to enforce remedies.”[15]  The Boston Generating court previously ruled that the same language did not constitute a waiver of a second lien creditor’s right to object to a sale motion, either in its capacity as a secured or unsecured creditor.[16]

  These loopholes, and others, proved disastrous to senior lenders.  Post-Momentive, notwithstanding conflicting case law relating to the enforceability of bankruptcy waivers,[17] senior lenders would be well advised much more aggressively and diligently to negotiate for protections which prevent junior creditors from taking restructuring or financing positions in the chapter 11 process that are opposed by senior lenders.

• Unsecured Creditor Rights:  In Boston Generating, the Court termed junior secured creditors’ retention of unsecured creditor rights under an intercreditor agreement “typical.”[18]  Nevertheless, the precise language of the carve-out itself may still be the subject of considerable negotiation.  Intercreditor agreements in Boston Generating and Momentive included broad carve-outs in favor of junior creditors.  The ICA expressly preserved second lien creditors’ rights as unsecured creditors “[n]otwithstanding anything to the contrary” in the document.[19]  Post-Momentive, senior lenders may argue that any carve-out must ensure that junior creditors cannot exercise their rights as unsecured creditors to vitiate the protections afforded to senior lenders under the express terms of the intercreditor agreement.  An example of this type of broader carve-out is set forth below.

  Except to the extent inconsistent with the terms of this Agreement, expressly including sections . . . , second lien secured parties may exercise any rights and remedies that could be exercised by an unsecured creditor. . .

   

  An alternative formulation of the provision arose in Ion Media where junior creditor rights as unsecured creditors were expressly subject to senior creditors’ insolvency protections, not the entire agreement.[20]

  Finally, the subordination agreement in Erickson Communities included even more aggressive language whereby subordinated creditors agreed not to “exercise any rights or remedies or take any action or proceeding to collect or enforce any of the Subordinated Obligations” until senior lenders were “fully satisfied.”[21]

• Claim vs. Lien Subordination:  The Momentive Court concluded that the ICA was not a claim subordination agreement; this established the context for its analysis of the Intercreditor Actions.[22]  Thus, while the ICA prohibited challenges to first priority liens,[23] it failed to subordinate second lien claims to first lien claims and failed to prohibit second lien creditors from opposing the asserted first lien claim amount.  Had the ICA, like the subordination agreement at issue in Ion Media, set forth express protections relating to the first lien claims, it would have prevented junior creditors’ intervention in the make-whole litigation and may have impacted the Momentive Court’s full analysis of the ICA.[24]  Section 3.1(iv) of the Boston Consulting intercreditor agreement sets forth the following more senior lender friendly restriction, and prohibits second lien creditors from:[25]

  oppos[ing] or otherwise contest[ing] any claim by the First Lien Collateral Agent (on behalf of itself or the First Lien Secured Parties), the First Lien Administrative Agent (on behalf of itself or any of the First Lien Lenders), or any First Lien Secured Party

   

  The Model Intercreditor includes a similar provision relating to post-petition obligations.[26]

• Proceeds of Collateral:  The ICA, following the Model Intercreditor, prohibited second lien creditors from receiving shared collateral or proceeds of shared collateral in connection with an exercise of remedies until senior creditors were paid in full in cash.[27]  This language proved to be far too restrictive.  First lien creditors asserted that the Momentive reorganization plan breached this provision by distributing to second lien creditors the reorganized entity’s equity on account of their claims without discharging the first lien claims in a cram-down scenario.  The Momentive Court rejected this argument, holding that post-emergence equity was neither shared collateral nor the proceeds of shared collateral.  Equity distributed under the Momentive Plan constituted proceeds of the defendant-creditors’ liens and claims, not the assets securing those claims.[28]  In light of this ruling, senior secured creditors may attempt to clarify that, even if the intercreditor agreement does not contain express claim subordination provisions, distributions received via an insolvency for purposes of the intercreditor agreement are presumed to be proceeds of shared collateral such that they trigger any waterfall provision under the intercreditor agreement as follows:

  For the purposes of this Agreement, there shall be a presumption that any distribution to or for the benefit of the second lien secured parties under any Plan of Reorganization for any grantor shall be on account of or by virtue of the Second Lien Collateral . . .

   

  While at least one court has held that Section 1129(b) of the Bankruptcy Code does not require either the bankruptcy court or the debtor to determine whether a plan violates an intercreditor agreement in order to confirm a Chapter 11 plan, the addition of the foregoing language would provide the first lien creditors with a much stronger legal basis for enforcing the intercreditor agreement’s turnover and distribution provisions, in whatever venue.[29]

  The extent to which the Bench Ruling will be followed uniformly by other courts is an open question.  The Momentive court’s strict contractual interpretation of the ICA’s insolvency provisions, however, is not unique.  The Bench Ruling finds support in Boston Generating and Ion Media and serves as a reminder of the stakes involved in careful drafting and negotiation of intercreditor agreements.

[1] Case No. 14-22503-rdd, [Docket No. 507].

[2] Case No. 14-22503-rdd, [Docket No. 325].  The parties to the ICA were the second lien creditors and two classes of first lien creditors, collectively referred to herein as the “first lien creditors.”

[3] RSA Ex. A.

[4] Plan §§ 5.4-5.5.

[5] Bench Ruling at 19.

[6] Id. at 19-20.

[7] Id. at 7.  See also In re Boston Generating, LLC, 440 B.R. 302, 318 (Bankr. S.D.N.Y. 2010) (an intercreditor agreement’s focus is to put first lien creditors “‘in the driver’s seat’ when it came to decisions regarding collateral”).

[8] Bench Ruling at 19.

[9] Id. at 20.

[10] Notably, the ICA did not address claim or debt subordination, although it did have a typical turnover provision requiring the second lien creditors to turn over to the senior creditors any collateral, or proceeds of collateral, received by such second lien creditors until the senior creditors were paid in full.

[11] Id. at 21.  See also In re Boston Generating, LLC, 440 B.R. at 318 (retention of unsecured creditor rights permits junior creditors to assert “arguments that are not expressly waived by the intercreditor agreement.”).

[12] ICA § 6.1(a).

[13] Bench Ruling at 21.

[14] A copy of the Model Intercreditor is annexed to the Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force dated March 22, 2010.

[15] ICA § 3.1(a)(ii).

[16] In re Boston Generating, LLC, 440 B.R. at 320.

[17] Compare In re Aerosol Packaging, LLC, 362 B.R. 43, 47 (Bankr. N.D. Ga. 2006) with In re SW Boston Hotel Venture, 460 B.R. 38, 52 (Bankr. D. Mass. 2011).

[18] In re Boston Generating, LLC 440 B.R. at 318.  But see In re Erickson Retirement Communities, LLC, 425 B.R. 309, 314 (Bankr. N.D. Tex. 2010) (denying motion for appointment of examiner where junior creditors agreed not to exercise any rights or remedies or commence any proceeding).

[19] See In re MPM Silicones, LLC, Adv. Pro. 14-08248 (Bankr. S.D.N.Y. September 29, 2014) [Docket No. 44, Ex. A].  See also In re Boston Generating, LLC, 440 B.R. at 320 (noting that carve-out had an “ill-defined scope”).

[20] In re Ion Media Networks, Inc., 419 B.R. 585, 598 (Bankr.S.D.N.Y. 2009).

[21] In re Erickson Retirement Communities, LLC, 425 B.R. 309, 313 (Bankr. N.D. Tex. 2010)

[22] Bench Ruling at 20.

[23] ICA § 2.2(a).

[24] See In re Ion Media Networks, Inc., Adv. Pro. 09-01440 (Bankr. S.D.N.Y. Oct. 13, 2009) [Docket No. 13, Ex. A]  (prohibiting junior creditors from opposing or objecting to “the value of any claims of the First Priority Secured Parties under Section 506(a) of the Bankruptcy Code.”).

[25] In re Boston Generating, LLC, (Bankr. S.D.N.Y. Aug. 19, 2010) Case. No. 10-14419 [Docket No. 18, Ex. A].

[26] Model Intercreditor § 6.8(a).

[27] Model Intercreditor § 4.1 (requiring “Collateral or Proceeds” to be paid first towards payment in full of all First Lien Obligations).

[28] Bench Ruling at 29.

[29] In re TCI 2 Holdings, LLC, 428 B.R. 117, 139 (Bankr. D. N.J. 2010).

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn lawyer with whom you usually work or the authors:

Michael A. Rosenthal – New York (212-351-3969, [email protected])
Josh Weisser – New York (212-351-5372, [email protected])

Please also feel free to contact the following co-chairs or any member of the firm’s Business Restructuring and Reorganization Practice Group:

Craig H. Millet – Orange County (949-451-3986, [email protected])
Michael A. Rosenthal – New York (212-351-3969, [email protected])
Jeffrey C. Krause – Los Angeles (213-229-7995, [email protected])
David M. Feldman – New York (212-351-2366, [email protected])

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