On September 11, 2014, New York Bankruptcy Judge Robert Drain confirmed a chapter 11 plan (the “Plan”) in the case of In re MPM Silicones, LLC (“Momentive”) that distributed to the second lien creditors all of the equity in the reorganized company, crammed down the senior lien creditors with replacement notes, and denied the seniors a makewhole payment. Several observers have analyzed Judge Drain’s confirmation decision, emphasizing the flexibility provided to reorganizing debtors from his resolution of these issues. Just as significant, though, is the related litigation in Momentive concerning an intercreditor agreement between the senior lienholders and junior lienholders.
Prior to plan confirmation, the first lien noteholders and “1.5 lien” noteholders (together, the “Plaintiffs”) brought two separate adversary proceedings alleging that in connection with the Plan and the aforementioned disputes a group of second lien noteholders (the “Defendants”) violated an intercreditor agreement governing the relationship and rights as between the senior and junior lienors (the “ICA”). The Plaintiffs alleged that the Defendants breached the ICA by intervening on the side of the Debtors in the make-whole payment litigation, entering into a restructuring agreement with the Debtors supporting the Debtors’ chapter 11 cramdown plan, and receiving property under the plan that the Plaintiffs alleged constitutes Common Collateral (as defined in the ICA) or its proceeds.
The property at issue in the dispute included (i) a potential $30 million dollar backstop fee that the second lien noteholders could receive for supporting a $600 million rights offering, (ii) payment of fees and expenses of the second lien noteholders’ professionals, and (iii) 100% of the reorganized company’s equity to be received by the second lien noteholders under the Plan. On September 30, 2014, Judge Drain issued a bench ruling on the motions to dismiss, dismissing the complaints with respect to the $30 million backstop fee, professional fees and new equity distribution.1 This Ruling is significant because it serves as a harsh reminder of the limits (or weakness) of the typical lien subordination prevalent in first lien/second lien structures. Judge Drain found that the ICA did not prevent the junior lienholders from taking various actions/positions or receiving distributions and a potentially significant backstop fee, despite the senior lienors not being paid in full in cash. The Judge narrowly construed the language of the ICA concerning the restrictions on the junior lienholders and broadly construed an exception to those limitations that preserved to the junior lienors their unsecured creditor rights.
The Ruling
Distribution of Property
The heart of the Ruling is lien versus claim subordination. The ICA provided for lien subordination (the subordination of the junior lienors’ rights to be paid from the Common Collateral), and not claim subordination (senior claims must be paid before junior claims, regardless of collateral).
Section 4.1 of the ICA provides a waterfall for allocation of collateral proceeds, stating “[a]fter an event of default under any First-Lien Indebtedness has occurred … so long as the Discharge of Senior Lender Claims has not occurred, the Common Collateral or proceeds thereof received in connection with the sale or other disposition of, or collection on, such Common Collateral upon the exercise of remedies, shall be applied by the Intercreditor Agent to the Senior Lender Claims … until the Discharge of Senior Lender Claims has occurred.” Under the definitions section of the ICA, “Discharge of Senior Lender Claims” requires “payment in full in cash[.]” Section 4.2 of the ICA then addresses what happens if a junior lienholder gets collateral or proceeds out of the order established in the waterfall: “[a]ny Common Collateral or proceeds thereof received by any Second-Priority Agent or any Second-Priority Secured Party in connection with the exercise of any right or remedy . . . relating to the Common Collateral in contravention of this Agreement shall be segregated and held in trust for the benefit of and forthwith paid over to the Intercreditor Agent (and/or its designees) for the benefit of the applicable Senior Lenders . . .” (emphasis added).
During argument, an attorney for the first lien noteholders maintained that the “right under the intercreditor agreement is for the senior lenders to be paid, in full in cash, the amount of their claims,” which Judge Drain forcefully rejected as arguing for claim/payment subordination as opposed to lien subordination: “That is clearly not the right. That would be a debt subordination. This is a collateral subordination. So your right is to receive the proceeds of your collateral until you were paid those proceeds in full in cash.” Judge Drain then turned to the question of what constitutes proceeds of the Common Collateral in connection with the proposed distributions to the Defendants.
First, Judge Drain dismissed the claims premised on the potential $30 million backstop fee. In his view, payment of the backstop fee was not the exercise of any right or remedy relating to the Common Collateral, the trigger to the ICA’s lien subordination provision. Instead, the Judge found the fee “would not be on account of a secured obligation but, rather, a separate, unsecured obligation undertaken by the debtors to the defendants for backstopping new exit financing for the debtors beyond the time provided in the Backstop Agreement.”
Second, turning to the claim that payment of the junior lien creditors’ professional fees derives from the exercise of remedies against the Common Collateral, the Judge dismissed the claim for deficient pleading and granted the Plaintiffs thirty days to amend the complaint to provide the required specificity.
Third, and economically most significant, the Judge concluded as a matter of law that the new equity to be distributed to the junior lien creditors is not proceeds of the Common Collateral. The Plaintiffs relied on the expansive definition of “proceeds” from the New York Uniform Commercial Code (as the ICA does not define proceeds), that the distribution of the stock is in respect of “rights arising out of” Common Collateral, thus making the stock “proceeds” of the Common Collateral. Judge Drain, however, took a holistic view on this issue and noted that under the Plan the Plaintiffs “continue to retain their liens on all of the Common Collateral. That collateral will not have been diminished one iota by the distribution of new stock under the plan to the defendants.” Since the collateral the senior lien creditors bargained for was not altered, in Judge Drain’s opinion, the new equity could not constitute proceeds of the Common Collateral, but, rather, was proceeds of the Defendants’ liens and claims. In other words, in Judge Drain’s view, the Defendants got the stock in discharge of their prior liens and claims, not in respect of the collateral itself.
Other Limitations and Exceptions
Judge Drain also ruled in favor of the Defendants concerning their intervention on the side of the Debtors in the make-whole payment litigation and support of the Debtors’ chapter 11 cramdown plan, narrowly construing the language of the ICA concerning the junior lienholders restrictions and broadly construing an exception in the ICA preserving unsecured creditors’ rights.
Presumably to further and augment the senior lienors’ rights in and with respect to the Common Collateral, the ICA contained various provisions purporting to limit rights and actions of the junior lienors. Section 3.1(c) of the ICA prohibits the second lienors from taking “any action that would hinder any exercise of remedies undertaken by the . . . Senior Lenders with respect to the Common Collateral . . . including any sale, lease, exchange, transfer or other disposition of the Common Collateral[.]” This section also waives any rights the second lienors “may have as a junior lien creditor or otherwise to object to the manner in which the . . . Senior Lenders seek to enforce or collect the Senior Lender Claims or the Liens granted in any of the Senior Lender Collateral . . .” First, regarding the make-whole litigation intervention, Judge Drain found all such restrictions in section 3.1(c) to be limited to the Common Collateral or actions with respect to it. Second, the Judge found that the ICA preserved the Defendants’ rights as unsecured creditors to take such action regarding both the make-whole intervention and support of the Debtors’ cramdown plan. Judge Drain highlighted section 5.4 of the ICA which provides “[n]otwithstanding anything to the contrary in this Agreement” the second lien noteholders “may exercise rights and remedies as an unsecured creditor[.]” The Judge construed this exception in the ICA broadly to preserve their rights as unsecured creditors’ to trump what arguably otherwise may have been a breach of section 3.1(c) of the ICA by the second lienors’ support of the cramdown plan.
Implications for Drafting Intercreditor Agreements
The Ruling is an important reminder that there are limits to the protection that lien subordination intercreditor agreements offer. If senior lienholders desire to restrict junior lienholders from taking actions against their interests, the intercreditor agreement must contain clear restrictive language not qualified by references to the common collateral. Such restrictions are fairly rote in debt subordination agreements (e.g., mezzanine debt financing). In lien subordination agreements, there are typically substantial restrictions on what a second lienholder can do, but it varies somewhat from agreement to agreement. In simple terms, the point of such restrictions is to make the second lienholder “silent” or close to silent, so that it is the first lienholder in charge if there is any credit event at the mutual borrower, with the second lienholder being more or less toothless and simply relying on asset valuation/liquidation for any recovery.
By the way of example, Judge Drain contrasted the “loosely drafted ICA” in Momentive with the “very tight language” in the agreement in In re Erickson Ret. Cmtys., LLC, 425 B.R. 309 (Bankr. N.D. Tex. 2010) where the junior lienholders essentially became “silent seconds” due to the restrictive language. Senior lien creditors that intend to share common collateral with junior lien creditors need to be aware of this ruling and carefully draft agreements to precisely reflect the intention of the parties. If senior lien creditors want broader rights, including subordination of rights to receive distributions of new equity in exchange for liens or claims (not just in exchange for the common collateral), generalized language providing for lien subordination is not sufficient, nor are restrictions qualified by references to common collateral. Moreover, this Ruling has implications for setting boundaries for the definition of “proceeds” of collateral. The UCC was amended in 2001 to expand the definition of “proceeds” in response to courts too narrowly construing the definition of proceeds in the prior version of the UCC. However, this Ruling arguably sets limits to this expanded definition by concluding that the new equity cannot be “proceeds” when the senior lenders’ collateral has not been altered in any way. In other words, unless the senior lienholders can show an alteration (e.g., decrease, substitution) of their collateral, courts following this Ruling will not find equity interests in the reorganized debtor granted to junior holders to constitute proceeds of the collateral.
If you have any questions concerning this Client Alert, please feel free to contact John R. Ashmead (212-574-1366) or Ronald L. Cohen (212-574-1515).
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1 In re MPM Silicones, LLC, 2014 Bankr. LEXIS 4353 (Bankr. S.D.N.Y. Oct. 14, 2014) (the “Ruling”). The Plaintiffs were granted leave to replead with respect to the Defendants’ alleged opposition to the Plaintiffs’ receipt of adequate protection, alleged support for the issuance of a new priming lien, and the alleged breach of the ICA regarding the Defendants’ professional fees.
