Gibson Dunn discusses Lien-Creditor Rights after Momentive

On October 14, 2014, the Bankruptcy Court for the Southern District of New York issued a bench ruling (as later modified, the “Bench Ruling“) in the In re MPM Silicones, LLC (“Momentive“) Chapter 11 cases (Case No. 14-22503-rdd, Adv. Proc. Nos. 14-08248 [Docket No. 50], 14-08247 [Docket No. 60]), which serves as a stark reminder of the function and importance of carefully drafted and negotiated intercreditor agreements in a Chapter 11 context.  Intercreditor agreements generally govern the rights of multiple classes of creditors vis à vis each other.  A typical intercreditor agreement directs future distributions post-default by the issuer and defines subject creditors’ ability to participate in both future enforcement actions against collateral and financial restructurings of the issuer.  The Bench Ruling underscores the adverse consequences to senior creditors if they do not negotiate for broad protections that anticipate collateral enforcement and financial restructurings, including Chapter 11 outcomes.

Facts:

The Momentive debtors filed for Chapter 11 relief on April 13, 2014.  Prior to filing, the company entered into a restructuring support agreement with certain holders of the debtors’ second lien notes (the “RSA“), which RSA formed the foundation for the debtors’ plan of reorganization (the “Plan“).  On June 23, 2014, over first lien creditor objections, the Court approved the Momentive debtors’ assumption of the RSA.[1]

Trustees for the two classes of Momentive first lien debt filed complaints against second lien creditors and the second lien trustee in a New York Supreme Court (as subsequently removed to the Bankruptcy Court, the “Intercreditor Actions“), asserting violations of the Momentive intercreditor agreement (the “ICA“).  Senior creditors alleged that second lien creditors’ execution of the RSA and performance thereunder created three separate ICA breaches:  first, by allegedly contesting first lien creditor requests for adequate protection; second, by intervening in an adversary proceeding commenced by the debtors to contest the first lien creditors’ asserted make-whole claims; and third, by supporting the company’s Plan itself.[2]  The final objection centered, in large part, on the Plan’s treatment of Momentive‘s secured debt.[3]  On the Plan effective date, second lien creditors received the reorganized Momentive debtors’ equity.  By contrast, the Plan offered first lien creditors a choice.  If the classes of first lien claims voted in favor of the Plan, first lien creditors would receive cash equal to the full amount of their claims, excluding any amounts recoverable as a make-whole premium or breach claim under the first lien loan documentation.  Conversely, if either class voted to reject the Plan, first lien creditors in that class would receive replacement notes with a present value equal to their full first lien claim, but reserve the right to litigate the claim amount.[4]  The proposed first lien treatment, thus, sought to compel first lien creditors to forgo a breach or make-whole claim as part of a consensual confirmation process.  Ultimately, both classes of first lien creditors overwhelmingly voted to reject the Plan, prompting a confirmation battle over the first lien claim amount and the terms of the replacement notes.

First lien creditors sought support for their breach allegations in various ICA provisions, certain of which directly curtailed second lien creditor action in an insolvency context.  Specifically, first lien creditors alleged that execution of the RSA (obligating second lien creditors to support the debtors’ post-petition financing) breached the ICA’s prohibition against section lien creditors’ contesting any first lien request for adequate protection.  Similarly, first lien creditors asserted the second lien creditors’ support for the Momentive debtors’ cram-down Plan violated ICA restrictions on second lien creditors’ receipt of collateral or proceeds thereof prior to the payment of all first lien obligations in full in cash.  Finally, first lien creditors asserted that the junior creditors’ intervention in the make-whole litigation generally constituted an “action that would hinder any exercise of remedies” by first lien creditors in violation of the ICA.[5]  No ICA provision directly prohibited claim objections.

Second lien creditors contested each allegation, and in particular, argued that their actions were consistent with their rights as unsecured creditors, rights preserved under the ICA “[n]otwithstanding anything to the contrary in [the agreement].”[6]

The Intercreditor Actions were dismissed by the Bench Ruling.

The Ruling:

The Momentive Court’s analysis of the ICA’s overarching purpose heavily informed its dismissal of the Intercreditor Actions.  The Court found that the ICA primarily served to define “parties’ rights in respect of shared collateral.”[7] In reaching this conclusion, the Court highlighted the second lien creditors’ broad retention of unsecured creditors’ rights and remedies against the Momentive debtors.  As the actions taken by the second lien creditors did not directly pertain to the senior creditors’ interest in shared collateral or any right “very clearly precluded or constrained” by the ICA, the Court refused to find the existence of contractual breach.[8]

The Momentive Court’s analysis of the second lien creditors’ intervention in the make-whole claim litigation illustrates the Court’s treatment of the parties’ relative rights under the ICA and its strict reading of the language of that document.  The ICA did not expressly prohibit second lien creditors from contesting the first lien asserted claim, and the Court rejected the argument that the second lien creditors’ intervention in the make-whole litigation could be construed as an attempt to hinder senior creditors’ ability to exercise their rights in violation of the ICA.[9]  In short, the Court declined to read into ICA provisions governing the parties’ respective rights as to collateral any restriction on junior creditors’ contesting the senior creditors’ asserted claim.[10]  Absent a specific and applicable prohibition, the ICA “must be read to give the [second lien creditors] the unfettered right to act as unsecured creditors to object to the senior lien holders’ claims.”[11]

The Court employed a similar analysis when evaluating arguments about subordinated creditors’ entry into the RSA and related support for the DIP financing and the Plan.  Again, the Court started from the basic proposition that second lien creditors, as holders of a substantial unsecured deficiency claim, retained their right to take any position unless expressly constrained by the ICA.  The ICA prohibited second lien creditors from objecting to DIP financing supported by first lien creditors and contesting any first lien creditor request for adequate protection.[12]  There was, however, no correlative restriction against second lien creditors either providing their own financing or supporting a financing provided by a third party, nor was there evidence on the record of second lien creditors’ having taken any position with regard to first lien adequate protection.  Finally, the ICA failed to establish any restriction regarding plan confirmation.  As a result, the debtors and the second lien creditors were free to enter into the RSA, notwithstanding its relation to the priming DIP financing or cram-down Plan.  Under the facts at issue, the Momentive second lien creditors, while taking actions adverse to first lien creditors’ interests, were simply exercising their rights as unsecured creditors, and these rights did “not conflict with any more specific provision in the ICA in a way that might create any contextual ambiguity.”[13]

Takeaways:

An intercreditor agreement seeks to allocate risk between the subject creditor classes.  Each intercreditor negotiation and, therefore, each intercreditor agreement represents a distinct series of compromises.  Indeed, the American Bar Association’s model First Lien/Second Lien Intercreditor Agreement (the “Model Intercreditor“)[14] is not so much a form agreement as it is a set of sample provisions to be selected based on the outcome of expected intercreditor negotiations.

Intercreditor negotiations reflect, among other things, the tension between two conflicting forces in the loan origination market.  On one hand, senior creditors have an incentive to negotiate for the greatest number of protections available.  On the other hand, the same senior creditors generally benefit from a robust second lien loan market (which offers issuers greater liquidity and senior creditors downside protection in a default scenario).  A general shift towards greater senior creditor protections could impair that market.  Lenders may be less willing to advance capital on a junior basis if they must remain completely “silent” in a future restructuring.  Yet a further complication is that the creditors that originally negotiate these arrangements may not be attentive to the same considerations as the creditors who might buy the paper in a default scenario.

The Bench Ruling’s interpretation of the ICA underscores the importance of intercreditor negotiations at loan origination.  In the future, senior creditors would be well advised to demand specific and far-reaching protections that cover more than pure collateral enforcement.  Indeed, Momentive could negatively impact the trading prices of first lien debt which lacks appropriate first lien intercreditor protections.

The full memorandum goes on to identify certain intercreditor points that may be the subject of increased focus and negotiation following Momentive.  The full and original memo was published by Gibson Dunn on November 12, 2014 and is available here.

 


[1] Case No. 14-22503-rdd, [Docket No. 507].

[2] Case No. 14-22503-rdd, [Docket No. 325].  The parties to the ICA were the second lien creditors and two classes of first lien creditors, collectively referred to herein as the “first lien creditors.”

[3] RSA Ex. A.

[4] Plan §§ 5.4-5.5.

[5] Bench Ruling at 19.

[6] Id. at 19-20.

[7] Id. at 7.  See also In re Boston Generating, LLC, 440 B.R. 302, 318 (Bankr. S.D.N.Y. 2010) (an intercreditor agreement’s focus is to put first lien creditors “‘in the driver’s seat’ when it came to decisions regarding collateral”).

[8] Bench Ruling at 19.

[9] Id. at 20.

[10] Notably, the ICA did not address claim or debt subordination, although it did have a typical turnover provision requiring the second lien creditors to turn over to the senior creditors any collateral, or proceeds of collateral, received by such second lien creditors until the senior creditors were paid in full.

[11] Id. at 21.  See also In re Boston Generating, LLC, 440 B.R. at 318 (retention of unsecured creditor rights permits junior creditors to assert “arguments that are not expressly waived by the intercreditor agreement.”).

[12] ICA § 6.1(a).

[13] Bench Ruling at 21.

[14] A copy of the Model Intercreditor is annexed to the Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force dated March 22, 2010.

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