2002 Factoring Conference Subordination 101: All a Factor Ever Wanted to Know

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2002Factoring ConferenceSubordination 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_at_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 parents creditors
  have claim on parents 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 creditors dividends and junior creditors
  dividends

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Contractual Subordination - Continued

• 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

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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
• Debtors assets liquidate in bankruptcy for
  600,000
• Senior Debt is 500,000 junior debt is 500,000
  and second senior creditors 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
  creditors 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 creditors 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 creditors agent
  the right to file claim in creditors 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 creditors
  risk -- same as guaranty so need contractual
  waivers
• Sample waivers

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Waivers

• The 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

38
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
  creditors right to receive payment of the
  secured debt or restrict enforcement of
  creditors claim against the debtor

39
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

41
Limitations on Enforcement of Remedies

• Generally, senior lienholder will want to limit
  or totally prohibit the junior lienholders 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

42
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.

43
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

44
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 estateobviously
  something Lender 1 does not want to do

45
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.

46
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

47
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.

48
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.

49
Effect of Non-Perfection of Senior Lienholders
Lien

• Facts
• Lender 1 has perfected lien in all of debtors
  assets
• Lender 2 wants to make loan to debtor secured by
  portion of debtors assets consisting of
  equipment
• Lender 1, to accommodate Lender 2s loan,
  subordinates its lien in debtors equipment.
• Debtor files bankruptcy and its bankruptcy
  trustee discovers that Lender 2 does not have a
  perfected lien in equipment.

50
Arguments and Strategy of Trustee

• Trustee will try to avoid Lender 2s 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 2s
  avoided first lien and the benefit of Lender 1s
  contractual agreement, the estate receives the
  first monies from the sale of the equipment to
  the extent of the amount of that lien.

51
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 2s mistake

52
Drafting Solutions

• Subordination by Lender 1 is conditioned upon
  existence of perfected, unavoidable security
  interest of Lender 2
• If Lender 2s 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.

53
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.

54
Circuity of Lien Problem

• Facts
• Lender 1, Lender 2 and Lender 3 all have liens on
  the debtors equipment in that priority
• Lender 1 agrees to subordinate its lien to Lender
  3
• Lender 2 does not enter into subordination
  agreement
• In debtors 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

55
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 1s first lien
• Cases are in conflict, but majority favor Lender
  3 on a limited basis

56
Majority Rule

• Set aside from proceeds of sale amount of Lender
  1s lien
• From that amount, pay claim of Lender 3 and any
  balance is used to pay Lender 1
• After amount of Lender 1s claim is distributed
  between Lender 3 and Lender 1, pay Lender 2 in
  full
• If any balance remains after Lender 1s 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

57
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

58
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.

59
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

60
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

61
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.