The impressive rebounding of leveraged credit activity in the middle-market arena has produced a surge in acquisition debt financing, often provided in tandem by two distinct players: asset-based lenders that provide formula-driven working capital facilities and cash-flow lenders that provide term loan financing. Secured credit providers in this area now routinely pursue a lien structure — often referred to as a “split collateral” structure — pursuant to which the ABL lender has a first priority lien on a defined pool of the borrower’s assets (usually receivables and inventory), the term lender has a first priority lien on a separately defined pool of the borrower’s assets (usually fixed assets, investment property and intellectual property) and each lender has a second priority lien on the other lender’s primary pool of collateral.
This article focuses on the key provisions typically found in a split collateral intercreditor agreement, and addresses the underlying nuances and tensions that result, in some cases, in more favorable treatment for the ABL lender and, in other cases, in more favorable treatment for the term lender.
Defining Collateral Pools
The first order of business in drafting a split collateral intercreditor arrangement is determining how to best articulate the respective pools of collateral in which each secured lender will have a first priority security interest. In all cases, that will depend on the nature of the business of the borrower and the other loan parties. The nature of that business will, in turn, often attract and define the types of lenders willing to finance the enterprise.
For example, a fixed-asset intensive manufacturing or distribution company will likely be an attractive financing candidate for a typical second lien term lender, whereas a service provider with few if any fixed assets will probably be more attractive to the cash-flow term lender. The cash-flow term lender may be less focused on the precision with which the collateral pie is sliced and the collateral value term lender more focused.
In any event, a typical division of the collateral pool might include the following assets, all subject to the ABL lender’s first priority lien: receivables, inventory, related ancillary collateral (such as general intangibles, excluding intellectual property, documents of title, bills of lading and other negotiable instruments), deposit accounts into which proceeds of accounts receivables are deposited and all proceeds of the foregoing, and the following mix of assets, all subject to the term lender’s first priority lien: machinery, equipment, real estate, intellectual property and the equity interests issues by some or all of the loan parties.
Priority of Rights
The priority of rights to insurance payments is generally not controversial when the payments are in respect of casualty losses to or condemnation of identifiable property, with the senior claim to the payments following the priority of the lien on the underlying asset. However, parties to a split collateral intercreditor arrangement should also consider the priority of their claims to various types of other extraordinary receipts, such as business interruption insurance. The cash-flow term lender will argue that it is more at risk than the ABL lender in the case of an interruption of the borrower’s business and therefore should have the superior right to such insurance payments. Another method of handling the allocation of such payments is for the secured lenders to share such payments ratably, based on the outstanding principal amount of debt owing to each lender on the date of payment of the insurance claim.
Once the priority of each lender’s security interest in a particular collateral pool, and each lender’s rights to extraordinary receipts have been established, each lender will then have, subject to a few carve-outs noted in the following section, the unfettered right (irrespective of the other lender’s subordinate security interest) to deal with that collateral, as well as the prior claim to the proceeds thereof (whether arising pursuant to an ordinary course asset sale or exchange or an exercise of secured party remedies).
Finally, although primarily an issue only when there is a collateral shortfall, the intercreditor agreement should address the proper allocation (whether pro rata or otherwise) between the lenders of proceeds arising from a sale of a unit or division of the business — and even the entire business where the buyer and seller have not stipulated and ascribed values to the various asset classes which comprise the sale.
Exercise of Remedies
As a general proposition, the split collateral intercreditor agreement will give the holder of the first priority lien on a particular pool of collateral the exclusive right, usually for a limited period of time, to exercise its Article 9 remedies and other statutory rights and remedies (including lien foreclosure and sale), and apply the proceeds thereof against the obligations owing to it by the loan parties until the holder of the first priority lien has been “paid in full.” “Paid in full” does not have the meaning one typically expects, and is discussed more fully in the following section.
The duration of the period of exclusivity during which the senior lien holder may exercise remedies without interference from the junior lien holder does vary, but the market seems to have formed a consensus around a 150-day period. Once the first priority lienholder initiates an exercise of remedies, it then has the exclusive right for an agreed-upon period to liquidate the collateral pool subject to its first priority lien and exercise other secured creditor remedies. During that period, the junior lienholder must forbear from exercising any of its rights with respect to such collateral. At the end of that period, the junior lienholder may then commence an exercise of its secured creditor rights and remedies with respect to the collateral pool subject to its second priority lien, if at that time the senior lienholder is not then diligently exercising remedies.
Keep in mind that even during the period of forbearance, the second priority lienholder is not restricted from exercising certain basic rights and remedies, including the filing of a proof of claim, taking action to protect or preserve its liens, the filing of responsive or defensive pleadings, exercising voting rights in a bankruptcy and bidding for collateral at a public or private sale.
Two specific concessions by the term lender in favor of the working capital lender are now commonplace in split collateral intercreditor agreements. After the term lender takes control of its priority lien collateral, it will agree to provide the ABL lender with: 1) access to the loan parties’ facilities for a period — often 90 days — for the purpose of completing inventory, examining books and records and conducting its own secured creditor remedies on the borrower’s premises (and will agree to defer delivery of possession of the premises to a third- party purchaser thereof for the same period of time) and 2) a license to use intellectual property, such as trademarks, for the purpose of enforcing its security interest in any of its priority collateral, such as disposing of inventory with all applicable trademarks intact. Note that such concessions are not necessary or made in a pure first lien/second lien intercreditor agreement.
The extent to which the holder of the first priority lien may apply proceeds of its primary collateral against the obligations owing to it by the loan parties continues to be a highly negotiated area in split collateral intercreditor agreements (although some practioners take the view that any discussion of a cap on the amount of proceeds of first priority lien collateral, which can be applied to the debt held by the first priority lien holders, has no place in a true split collateral intercreditor agreement; that is, one where there is an abundance of both working capital and fixed assets, as each lender should be relying on the liquidation value of its own collateral in order to be paid in full).
The basic proposition made by the term lender is that while it is willing to have a subordinate lien on the collateral pool subject to the ABL lender’s first priority security interest, the senior lien holder should not enjoy unlimited benefits of its priority status, but rather should have a benefit limited to a clearly defined dollar amount. In other words, the term lender will argue that the ABL lender’s first priority lien may secure up to “x” dollars only and that any proceeds of the collateral pool in which the ABL lender enjoys a first priority lien may be applied by the ABL lender to the obligations owing to it will be capped at such amount. For example, if at the time the ABL lender initiates an exercise of remedies the outstanding balance of the revolving loans made by it to the borrower equals $37 million, the amount of the dollar cap agreed to in the intercreditor agreement equals $32 million and the proceeds of the collateral pool subject to the ABL lender’s first priority lien equal $34 million, then the waterfall provisions of the intercreditor agreement would permit the ABL lender to retain and apply against the revolving loans only $32 million, and would then obligate the ABL lender to turn over the remaining $2 million of collateral proceeds to the term lender.
The greater the term lender’s orientation to collateral values and to the preservation for its own benefit of the equity in the collateral pool in which it has a second priority lien, the more likely the term lender will be to press not just for a specific dollar limitation but for a formula-based limitation predicated on advance rates, whichever amount is less. This has become an area where the split collateral intercreditor agreement displays a range of disparate approaches to the term lender’s concern and the willingness of the formula-based lender to accommodate those concerns.
Some term lenders, particularly those with a strong cash-flow orientation, are satisfied with the implementation of only a dollar cap in the Waterfall section, typically equal to an amount that is 5% to 10% above the amount of the revolving credit commitment. Similarly, some ABL lenders will only agree to be bound by a stated dollar cap and take the position that a cap based on advance rates against the collateral pool unfairly permits the term lender to take advantage of formula limitations that were designed to shield only the ABL lender from risk. Other term lenders, those less oriented to cash-flow and more appreciative of collateral values, will insist that the cap on the amount of collateral proceeds, which can be applied to the revolving obligations must equal the lesser of a fixed dollar amount or an amount equal to a percentage of eligible collateral, plus an agreed upon amount for over advances, plus an agreed upon amount for other credit accommodations (such as hedging obligations). This approach effectively requires the ABL lender to carefully police its loan to collateral position at all times, so as to ensure that a liquidation following an over-advance will not cause the ABL lender to be “under water” vis à vis the term lender. Whichever approach is adopted, the split collateral intercreditor agreement will then provide that the ABL lender is paid in full, not when all obligations owing to it have actually been fully paid, but at such time as the aggregate amount of proceeds of the collateral pool in which it has a first priority lien has reached the agreed upon cap.
A few final observations regarding the Waterfall: 1) If an ABL lender agrees to the type of two-pronged cap described above, it must insist that the formula-based prong contain sufficient leeway so as to take into account the making of both intentional out-of-formula loans (whether as protective over advances or otherwise) and the existence of inadvertent over-advances (in cases where collateral values dissipate following the date a within-formula advance is made), and 2) unlike first out/last out or first lien/second lien intercreditor agreements, the split collateral intercreditor agreement does not require that collateral proceeds be applied in a particular order in the case of revolving obligations or in the case of term loan obligations.
Next month, in Part 2 of this two-part series, we will continue the discussion on split collateral intercreditor agreements, touching specifically on DIP financing and adequate protection, limitations on modifications to loan documents and the purchase option.
Robert B. Stein is partner and Financial Services Practice group leader at Blank Rome LLP.
To read the next installment of this two-part series, click here.