Navigating Intercreditor Agreements: Essential Features and Considerations

What is an Intercreditor Agreement

An intercreditor agreement functions as a contract between two or more parties that have extended financial credit to a third party. The third party generally includes both debtors and creditors, and the agreement helps to regulate their rights and obligations following the potentially adverse events set forth in the agreement. In most cases, an intercreditor agreement is used to help separate active creditors from passive creditors and to streamline the processes that must take place in excess of the stated amounts (i . e., bankruptcy). In many cases, active creditors hold senior debt and require collaboration from passive creditors. Active creditors aim to protect their interests by putting pressure on a third party (i.e., debtor) to comply with provisions set forth in the intercreditor agreement. Intercreditor agreements are regularly used in commercial lending, such as loans and leases. In addition, intercreditor agreements may be incorporated in real estate transactions.

Common Components of an Intercreditor Agreement

As previously mentioned, the intercreditor agreement is typically entered into by the debtor and two or more creditors of the debtor, and sets forth the relative priorities of those creditors.
Terminology varies somewhat depending on the particular industry or sector involved, but the following terms are common: The debt due to the senior lender must be paid in full and all commitments to make loans or provide credit under the senior credit facility must have terminated before any payment or distribution can be made to the junior lender.
The junior creditors collectively would enforce their rights against the collateral through the agent who holds a security interest in the collateral (in most cases, the junior creditors’ security interest would be subordinated to the security interest of the senior lender) (this is sometimes referred to as a "springing lien"). The junior creditors may, when permitted by the applicable intercreditor agreement: (i) take foreclosure action against the collateral and/or (ii) release the collateral. If no secured debt is involved, the junior creditors would enforce their rights directly against the borrower.
As a result of the power conferred upon the agent, agreements often include so-called "majority rules" provisions, which require the approval of a specified majority of all creditors subject to the agreement in order for particular actions to be authorized by the agent and the applicable class of creditors. Based on the credit risk associated with the borrower and on the relative priorities of the debt instruments of the various lenders, the intercreditor agreement will contain provisions that contemplate various payment arrangements between the different classes of debt (e.g., pro rata payment, sequential payment and lock box). In a typical scenario, once the senior debt has been satisfied in full, distributions will be made to the junior lenders until the agreed term and roll-up payments have been accomplished, at which time amounts will be distributed pro rata between the junior lenders according to the nature of their loans (e.g., senior unsecured loans versus subordinated loans). To the extent there are excess funds available after the repayment of the senior debt and the agreed term and roll-up payments to the junior lenders, the balance will then be paid to the equity holders.

Operation of Intercreditor Agreements

The mechanics of intercreditor agreements are often complex. A simple fact of business is that one creditor may be granted collateral with a larger security interest than another creditor. Other times, a creditor has a different grant of security and a different seniority in the collateral. Intercreditor agreements can apply to many different forms of debt, including mortgages on real estate and security interests in personal property. One of the most common forms of an intercreditor agreement is one between lenders and investors in long-term corporate bonds, also known as junk bonds.
The basis for all intercreditor agreements is seniority. For example, suppose a corporation has $3 million of bonds secured by a senior lien and $2 million of bonds secured by a junior lien. The proceeds from a liquidation of collateral are customarily distributed first to the senior bondholders, who will be made whole. The junior bondholders then receive what remains. If something unexpected happens, like a decrease in asset value, the junior bondholders may not get anything. The purpose of the intercreditor agreement is to settle the terms between the lender and investor who might lose out on one of these secondary arrangements and the more senior creditor.
Intercreditor agreements are designed based on their own priority. This is because creditors have different priorities. Because of the differences, there’s nothing unusual about there being subordinated debt. Those who have subordinated debt are only going to get paid after others with senior debt are paid. An intercreditor agreement may be used to make sure that creditors with subordinated debt don’t object to taking less than they’re owed in the event of a liquidation. In fact, an agreement may cause those creditors to waive their claim to remaining collateral.

Advantages and Disadvantages of Intercreditor Agreements

Both creditors and borrowers often recognize the benefits of using intercreditor agreements in their financing transactions. However, the resulting bargain struck in an intercreditor agreement can produce unanticipated pitfalls if not adequately negotiated. One of the more significant benefits to a borrower is that an intercreditor agreement can help facilitate its attempts to seek financings below the level of its senior lender debt. For example, the borrower facing a liquidity crunch might seek to raise a $50 million second lien debt tranche due to the constraints of its existing first lien lenders. If the senior lender holds not only a first lien on its collateral, but also equity in the borrower and a lock up on junior lien financings, this transaction will likely be terminated midway through negotiations, if not sooner. That said, even if the borrower can accommodate this senior lender concern, the parties will have to deal with how to address the further downstream lenders who will require a level of compensation in exchange for subordination to the first lien lenders. Nevertheless, there are benefits to the first lien lenders too, including, among other things, a reduced risk that the borrower will be unable to access financings other than at an enhanced interest rate, which could lead to deterioration of the underlying collateral due to its reduced value. Intercreditor agreements also tend to be used to (i) restrict junior lien claimants from contesting about collateral liquidation procedures and other restructurings, (ii) restrict them from pursuing their own collection remedies, and (iii) require the junior lien claimants to share the proceeds of collateral recoveries with senior lien holders. What can be lost in an intercreditor agreement? For one thing, ownership rights in collateral may become irrelevant, if those rights will never be exercised by the junior lien holders. There is also a reduction in flexibility for the junior lien holders, if, for example, they are no longer to pursue remedies that they believe may be necessary to protect the value in the assets securing or expected to secure their debt.

Intercreditor Agreements and Subordination Agreements

Intercreditor Agreements provide the creditor priority when multiple creditors are vying for the same collateral. It should be noted however that it is not a substitute for subordination agreements. Subordination agreements provide differing rights to each creditor to the identified collateral. Thus, it is a negotiation between the creditors as to how the proceeds from the collateral will be split.
Under a typical Intercreditor Agreement, the first in time creditor has priority in the identified debtors’ collateral. A subordination agreement may provide for a differing right to any of the creditors , such as the second in time creditor receives some payment while the first in time creditor must wait for payment. Other scenarios may be the first in time creditor is only allowed to recover costs for collection while the second in time creditor is reimbursed first. While the Intercreditor Agreement can be broad, it is typically used in the Loan Agreement phase where a bank is negotiating with multiple lenders. In contrast, the Subordination Agreement is usually used when one creditor is seeking to protect its right to collateral that was previously encumbered with another lender.

Key Legal Considerations in Intercreditor Agreements

Parties must consider a number of legal factors in drafting an intercreditor agreement. Because the agreements are often used to govern complex financial arrangements involving multiple parties and security types, the scope and level of detail contained in a typical intercreditor agreement can be quite extensive. Similar to a subordination or standstill agreement, where one creditor agrees to subordinate its rights to another creditor, an intercreditor agreement frequently involves a value multiple in defining the level of post-default subordination between creditors. The agreement may also impose strict requirements on when certain creditors can accelerate their debt or exercise remedies such as attaching or disposing of collateral. When negotiating loan documentation, the creditor that is subordinate to another creditor may seek reassurance that it has retained the right to control the process in the event of a default or bankruptcy, or at the very least, receive timely and meaningful notice of significant proposed actions. The extent to which that reassurance is possible will depend upon the intent of the parties to be bound by the intercreditor provisions even after the dates set for repayment have long expired.
Because the agreement will be governed by the laws of a particular state (and litigated in courts applying the law of that state), the legal principles that affect a creditor’s ability to rely upon a subordination or standstill agreement may vary by state. Courts generally enforce agreements entered into between sophisticated parties, but they can be reluctant to enforce overly broad intercreditor provisions. It is not uncommon, therefore, to find that a creditor has secured the same credit facility more than once, believing that the prior intercreditor agreements may not withstand judicial scrutiny if challenged. In addition, if the agreement has not been properly documented and recorded, or if sufficient notice of the restrictions in the agreement has not been given to other creditors, a court may not enforce its terms.
Parties must also be aware of jurisdictional issues that can affect their rights under intercreditor agreements. For example, in Camden v. Compton & Westerdahl, P.C., 2013 U.S. Dist. LEXIS 108303 (D. Utah July 24, 2013), a federal district court for the District of Utah was asked to decide whether it had subject matter jurisdiction to hear a case involving interpretation of an intercreditor agreement. The holders of a mortgage note were suing a second trust deed holder who lost the property due to a foreclosure sale, seeking to enforce rights under the intercreditor agreement. The court held that the case should not be heard because the intercreditor agreement was negotiated in states other than Utah that had no connection to the debtors in the transaction involving the property at issue. The court explained that an intercreditor agreement entered into by creditors in different countries (where jurisdiction might be agreed upon in the agreement) is quickly converted into a national agreement (governed by a federal court) once a person other than a creditor or its affiliate seeks to enforce the agreement, even where another country has previously declared itself the proper forum. The issue presented in Camden will clearly be relevant to lenders who have multi-state or multi-national portfolios with subsidiaries or affiliates that are preparing agreements between creditors over the disposition of collateral and the distribution of proceeds of their liquidation.
Other legal considerations include fiduciary duties arising under agency and trust law. Parties may need to address the extent of each agent’s duty to act in the interests of all creditors and any fiduciary duties owed by one creditor to another. The need to handle these issues by including appropriate language in intercreditor agreements can be essential for successful inspection rights. The agreement may also be required to specify that lenders who are also equity holders may be able to transact business free from fiduciary duty obligations. Finally, where the parent of a debtor files for bankruptcy, the right of a secured creditor to pursue collateral in chapter 11 bankruptcy can be limited under restrictive provisions in the Bankruptcy Code. If the intercreditor agreement does not specifically address the impact of the bankruptcy process on its operation, the creditor may be left with little choice other than to accept the result. Yet by the same token, documenting procedures within a bankruptcy proceeding without careful attention can be a risky business: a revision of one sentence in a document intended to limit overreaching in bankruptcy could render an entire section of an agreement invalid and subject the document to bankruptcy court review.

Case Studies on Intercreditor Agreements

In the world of finance, structuring deals to protect lenders is paramount. These structures often require the creation of intercreditor agreements that are designed to address the two sides of a bankruptcy creditor: secured and unsecured. In many bankruptcy cases for complex entities, the post-petition financing and exit financing for the reorganized entity takes precedence over pre-petition secured lenders. The treatment of pre-petition secured lenders frequently requires the forced expansion of their liens (sometimes referred to as "liens on steroids") and entry of a cash collateral order that treats cash of the debtor as collateral for certain types of post-petition financing. In addition, exit financing frequently "primers" pre-petition secured lender liens.
In the chapter 11 cases of Dynegy Holdings, CTC Communications and US Concrete, intercreditor agreements allowed the debtor to "prime" pre-petition lenders in exchange for enhanced treatment. In Dynegy, the sponsored exchange of pre-petition debt for new notes allowed the efficiency of the chapter 11 case in exchange for the pre-petition lenders relinquishing some of their pre-petition collateral. Dynegy also helped craft a solution for the pre-petition lenders in exchange for a limited credit bid and a second lien exit facility which the pre-petition lenders were able to use. In CTC, the agreement between debtor, unsecured creditors’ committee, second lien lenders, pre-petition bank group and noteholders allowed the company to merge with a competitor. The agreement permitted all pre-petition bank lenders to be repaid in full and the second lien lenders were able to become the debtor’s senior lenders. The second liens secured financing while leaving some assets unencumbered. In the chapter 11 case of General Growth, the capital structure included mortgage backed debt obligations ("CMBS"), junior debt and a huge equity infusion by the real estate giant Blackstone . With sufficient cash flow to continue operations, the debtor was able to emerge from chapter 11 through the negotiated rights of the secured lenders to enforce their liens through consensual foreclosure or credit bid of real assets. The intercreditor agreement divided the CMBS lenders into four classes (i.e. super-senior Bpieces segment, senior A1 segment, senior A2 and A3 segments and senior A4 segment) with different rights regarding credit bidding and foreclosing on their collateral. The unsecured debt holders accepted a very small recovery of about 10% of their debt in exchange for their unsecured debt. For the unsecured holders to receive a recovery, the equity holders had to give up a large part of their equity ownership. The final equity ownership structure was Blackstone (40%) and the CMBS holders (approximately 10% each). The senior class A1 and A2’s represented 90-100% of the common stock holders. As a condition to their authority to foreclose, the CMBS holders were required to give DIFCO (i.e., the entity formed by Blackstone to acquire a majority interest in the debtors) the opportunity to "mandatory put" the debt to the funds responsible for each class of CMBS debt. Unsecured debt holders formed the official unsecured creditors’ committee. In the end, the debtors emerged from bankruptcy in November 2009. In the chapter 11 case of FairPoint Communications, the intercreditor agreement allowed junior (unsecured bondholders) and senior (bank lenders) to avoid a full-blown battle with each other regarding the size of the secured lenders’ lien and what would constitute a "borrowing base" under the senior lenders’ credit agreement. The unsecured bondholders were willing to exchange some portion of their debt for over 90% of the reorganized common stock in the company if certain conditions were met. The intercreditor agreement eliminated many of these issues and created a procedure for the unsecured bondholders to receive new debt securities in exchange for old debt securities. The unsecured bondholders were given the opportunity to subscribe for new debt securities on a pro rata basis.