May __, 2006
Prepared by Paul Leake for the INSOL 2006, Conference in Scottsdale and first published
in the CDRO
Dynamics Between First and
Second Lienholders In Bankruptcy Cases
Paul D. Leake1
Second lien financings, consisting primarily of second lien term loans designed for sale in
the institutional market and second lien high yield bonds, have become an increasingly popular
option among both borrowers and investors. Although senior lenders traditionally are uneasy
about sharing their collateral with other lenders, they are willing to do so where they can protect
their interest in the common collateral through an intercreditor agreement that effectively limits
the rights that junior lienholders would otherwise enjoy as secured creditors.
Intercreditor Agreements
While the language of certain terms of intercreditor agreements is becoming somewhat
standardized, the extent to which a junior lienholder's rights are limited remains the subject of
robust negotiations between the parties. Intercreditor agreements include many provisions that
deal with issues that arise in bankruptcy cases:

Lift Stay Waiver. Requiring an advance waiver from the junior lender of its right
to contest any motion filed by the senior lender seeking to lift the automatic stay
to permit the senior lender to proceed against the common collateral;

Voting Rights/Plan Support. Allowing the senior lender to vote the junior lender's
claim to accept or reject a plan of reorganization, or requiring an agreement that
the junior lender will not support a plan opposed by the senior lender;

Asset Sales Consent. Requiring the junior lender to consent in advance to any
asset sale under section 363 of the Bankruptcy Code, 11 U.S.C. §§ 101-1532 (the
"Bankruptcy Code") supported by the senior lender;

Adequate Protection. Prohibiting the junior lender from seeking adequate
protection of its interest in the common collateral until the senior lender has
received satisfactory adequate protection of its interest;

DIP Financing/Cash Collateral. Requiring the junior lender to consent in advance
to the priming of its liens by any debtor in possession ("DIP") financing provided
1
Paul D. Leake is a Partner with Jones Day in New York and is co-head of the Firm's Business
Restructuring and Reorganization Practice Area and Coordinator of the Corporate Practice in the Firm's New York
Office. This executive summary provides an overview of the issues addressed in an article of the same title included
in your conference materials. The article was prepared by Paul Leake with the assistance of Daniel B. Prieto and
Robert J. Jud, associates with Jones Day in Dallas, Texas and members of the Firm's Business Restructuring and
Reorganization Practice Area.
by the senior lender, and to consent in advance to any use of cash collateral
approved by the senior lender;

Release of Lien. Mandating the automatic release of the junior lender's liens in
the event of any disposition of the common collateral pursuant to the senior
lender's loan documents;

Exercise of Remedies. Prohibiting the junior lender from exercising any remedies
against the common collateral for a specified period of time;

Challenge Rights. Prohibiting the junior lender from challenging the validity or
priority of the senior lender's liens;

UCC Rights. Modifying certain rights granted to junior lenders by the Uniform
Commercial Code, including the right to (i) demand that the senior lender marshal
assets; (ii) notice before a senior lender liquidates common collateral; (iii) sue a
senior lender for failing to conduct a foreclosure sale in good faith or in a
commercially reasonable manner, or failing to use reasonable care in the
preservation of the common collateral; and (iv) object to a strict foreclosure; and

Right of Redemption. Waiving the junior lender's right of redemption.
Enforceability of Intercreditor Agreements In Bankruptcy
Courts have issued conflicting decisions as to whether certain terms of intercreditor
agreements that impact a junior lender's rights under the Bankruptcy Code are enforceable in
bankruptcy. Section 510(a) of the Bankruptcy Code provides that "[a] subordination agreement
is enforceable in a case under this title to the same extent that such agreement is enforceable
under applicable nonbankruptcy law." Some courts have followed the plain language of the
statute and enforced intercreditor agreements according to their terms. Other courts interpret the
statute more narrowly and hold that the intent of section 510(a) is to allow creditors to
contractually alter the priority of payment amongst themselves, not to allow them to alter the
parties' other rights under the bankruptcy laws.
Courts adhering to the narrower interpretation of section 510(a) have refused to enforce
(i) provisions prohibiting a junior lienholder from seeking adequate protection of its interests and
(ii) provisions allowing a senior lienholder to vote a junior lienholder's claim to accept or reject a
debtor's plan of reorganization. Courts adopting the broader reading of section 510(a) have
enforced provisions in intercreditor agreements authorizing the senior lienholder to vote the
junior lienholder's claim. The ambiguity in the case law has encouraged junior lenders to
challenge the enforceability of other provisions of intercreditor agreements, including, in one
case, a provision in a DIP financing order that purported to confirm the enforceability of the
intercreditor agreement generally. The second lienholders objected to conceding the
enforceability of, among other provisions, a provision that provided the senior lender with
advance consent by the junior lender to the priming of the junior lender's liens by any liens
granted to a senior lender under DIP financing provided by the senior lender. Although it does
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not appear that the court decided whether such DIP financing provisions are enforceable, the fact
that these provisions are being challenged underscores the uncertainty in the law.
Need for Separate Grants of Security Interests
A senior lender frequently will insist on separate loan documents containing individual
grants of security interests for the senior and junior liens in order to protect its right to, among
other things, postpetition interest on an oversecured claim. Although separate documentation
can increase transaction costs, this practice may be warranted in light of a decision of the United
States Bankruptcy Court for the Southern District of New York, which held that a debtor had
granted only a single lien even though the debtor had granted separate security interests in the
same collateral to three different lienholders because the security interests where granted under
the same security agreement.
Postpetition Interest — The End of the Rule of Explicitness
Traditionally, the enforceability of a provision in intercreditor agreements granting a
senior lender the right to receive postpetition interest on its unsecured or undersecured claim
before any payments are made to the junior lender has been governed by the "Rule of
Explicitness," an equitable rule of construction that allowed senior lenders to recover postpetition
interest only if the subordination agreement permitted the recovery in precise and unambiguous
language. A recent decision from the United States Court of Appeals for the First Circuit,
however, has cast doubt on the continuing vitality of the Rule Of Explicitness. The First Circuit
held that the Rule of Explicitness was abrogated by the enactment of the Bankruptcy Code. The
First Circuit instead applied traditional state law rules of contract construction to determine
whether to enforce the postpetition interest provision.
Dynamics Between First and Second Lienholders in Recent Cases
Although decisions regarding the enforceability of the provisions of an intercreditor
agreement garner most of the attention, other issues implicating the dynamics of the relationship
between first and second lienholders have also arisen in recent cases. Among the most
interesting are the following examples:

Junior lienholders seeking to purchase assets out of bankruptcy and obtain a
distribution on their claims must either pay in cash, obtain the consent of the
senior lienholders or await the confirmation of a plan of reorganization.
Westpoint Stevens, Inc., 333 B.R. 30 (Bankr. S.D.N.Y. 2005).

Financing-related provisions in an intercreditor agreement can severely and
adversely affect the debtor's ability to fund its chapter 11 case. American
Remanufacturers, Inc., Case No. 05-20022 (Bankr. D. Del.).

In certain situations, junior lienholders can secure a significant competitive
advantage at an auction of the debtor's assets by using credit bidding to effectively
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reduce their acquisition costs. Horizon Natural Resources Company, Case
No. 02-14261 (Bankr. E.D. Ky.).
Conclusion
In recent years, second lien financings have increased in popularity with both borrowers
and lenders. As demonstrated above, first lien lenders must be mindful of the relative
importance of the various protective provisions in intercreditor agreements available to first lien
lenders as well as the uncertainty surrounding the enforceability of these provisions in the event
of a bankruptcy filing. Likewise, second lien lenders must be aware of the material impact that
provisions in intercreditor agreements that are not solely "lien subordination" provisions may
have on their rights and recoveries. In light of this uncertainty, lenders should be vigilant and
stay informed regarding the current state of case law in this area.
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