Intercreditor Agreements: An Overview
An intercreditor agreement is a type of contract between two or more parties who hold a debt from a common debtor, known as the obligor. Its principal purpose is to resolve conflicts that arise from competing legal and equitable interests in collateral. Intercreditor agreements are a common third party contract within a syndicate debt structure.
As such, the obligor will often use an intercreditor agreement to establish the relative positions of the lenders among themselves and between the lenders and the obligor. More specifically, the intercreditor agreement is used to determine what rights, if any, the subordination lender will have with respect to the collateral position, including its rights to payment by the obligor, and to participate in enforcement actions with, and distributions from, the collateral, including the ability to direct debtors. Further, and depending on the asset class involved, an intercreditor agreement can provide for "jeopardy pricing" or default interest when collateral securing senior debt is in danger.
All intercreditor agreements have a grant of security interest as their foundation and often require the obligor to prepare and file all requisite financing statements and take other actions as needed to perfect the security interest by way of a first priority lien on the collateral. The agreement also typically provides for automatic subordination of the subordination lender to the senior lenders, in addition to provisions establishing a cross-collection process (whereby senior lenders may redirect the subordinated lender’s distributions where they are not permitted under the agreement), standstill periods, a partial subordination process, subordination triggers (when the subordination lender may act independently of the senior lenders) and standstill exceptions (where the subordination lender may use cash collateral) .
As a practical matter, an intercreditor agreement is needed in multi-lender structure to protect each credit group or lender from the other credit group or lenders. The following example illustrates this protection. Suppose that Institutional Lender A provides a term loan facility for $100,000 and holds the first priority lien on all assets of the company. Later in time, Asset Based Lender B provides a revolving loan facility for $75,000 and holds a second priority lien on all assets of the company and working capital receivables. In a typical case, the company has been doing well and owns the collateral and retains a long-term plan to repay the loans in full. With time, Lender A’s loan is paid down. However, along the way, Lender A allowed and consented to certain changes in the lending structure and company business that impaired Lender B’s priority. Eventually, Lender B’s loan is also paid down. Now, after paying out both loans in the right priority, neither lender will have recourse to the company’s long-term assets. These assets are left to the equity holders.
An intercreditor agreement would have prevented competing priorities between the loans of Lender A and Lender B. Instead, as the parties had agreed in the intercreditor agreement, Lender A would have retained its first priority lien and helped to protect the position of Lender B by limiting modifications to the loan structure with respect to the priority rights of Lender B in the company’s working capital assets.
Terms in Intercreditor Agreements
Intercreditor agreements contain a number of specific terms and clauses, which can be divided into those applicable to creditors and those applicable to security providers. As the intercreditor agreement is an agreement between creditors or security providers rather than with the issuer, the terms applicable to creditors and those applicable to security providers will often affect one another. Most of the key terms or clauses will be found particularly in the sections relating to rights and priorities of each class of creditors or security providers which we now look at in more detail.
The Priority of Payments Intercreditor agreements also generally contain a clause on the order in which funds are to be applied to satisfy the claims of creditors under the secured financing documents. This clause is often include the following: ● a priority of payments clause – which is a clause setting out the order in which amounts received from the issuer e.g. is to be paid to the various creditors (or bondholders); ● a super priority clause – providing for super priority (or first lien) security and on who has super priority or first ranking security; and ● a payment waterfall – which is a clause setting out an order of payments (and is often referred to as a waterfall), which provides for payments to be made first to senior lenders before subordinated creditors. Part Equity Senior (or senior creditors, lenders and the like) will often require there to be an equity cushion, which will be a condition to intercreditor agreement, meaning that they will receive the full amount they are owed if the issuer’s assets are sold or realised on. Subordination Intercreditor agreements usually require subordination of all subordinated debt either as a result of their terms and conditions or by the intercreditor agreement itself to the extent the terms and conditions do not do so. Enforcement Rights Most intercreditor agreements confer rights on senior creditors or lenders to enforce their security if there has been a default or event of default in respect of senior debt or payments due on the bonds. If an event of default under senior debt occurs, this will usually entitle senior creditors to enforce their security without taking account of any subordinated debt. There will often be a clause setting out when the senior creditors or lenders can enforce their security once an event of default has occurred, usually following a certain period of time. Covenants/ Representations Intercreditor agreements usually contain the same or similar covenants and representations that are contained in the terms and conditions of the relevant bond or loan documentation. Particular Rights of Subordinated Creditors It is usual for intercreditor agreements to be beneficial to senior creditors owing to security they hold over the issuer’s assets. Certain rights may be conferred on subordinated creditors, although these are likely to be limited to the rights listed below. All or most of the terms referred to in the sections above will usually be found in intercreditor agreements, although they may be contained in different sections of the agreement (or document). It is clearly important for creditors and security providers to carefully consider the provisions of intercreditor agreements as it may have a material impact on their rights.
Advantages of Intercreditor Agreements
From the perspective of lenders and investors, intercreditor agreements enable them to establish the ranking of their security rights at the outset. Lenders will know who ranks ahead with respect to the relevant collateral and how subordinated lenders’ rights will be subservient to their priority position. This will add commercial certainty and allow the lenders to assess the overall risk of the proposed financing in determining its creditworthiness of the borrower (without having to further research the third party agreements, nationalities of the parties or search for the subordinate collateral). The intercreditors will be able to execute their security interests subject to the priorities and subordination terms clearly set out in the relevant agreement.
For the borrower, it provides more flexibility in that the borrower will have greater ability to negotiate the specific terms in the intercreditor agreement with respect to the subordination mechanism and the amount of other indebtedness that can be guaranteed without causing a subordination event. Generally speaking, without such agreements, subordinated lenders may resist the perfecting of any security interests in collateral until the senior lenders’ security is perfected and may not agree to provide financing until the senior lenders’ security has been perfected. In addition, as discussed below, the absence of intercreditor agreements may lead to complex and costly disputes between financiers if one or more of the parties claim that they have security interests covering all of the same assets.
Risks and Issues
While Intercreditor Agreements can form an important part of a lender’s risk mitigation strategy, the following should be considered when drafting such agreements:
On what basis have the lenders arrived at their respective entitlements to the available credit? Has this basis been properly documented? The Intercreditor Agreement should provide sufficient clarity over each lenders’ share of the available loan facility to avoid any future disputes. As with all contractual arrangements, the terms and conditions are open to interpretation by the Courts and any ambiguity may potentially be construed in a manner which was not originally intended by the parties – a comprehensive Intercreditor Agreement reduces the likelihood of this occurring.
What considerations need to be given to the security being provided and any related insolvency issues? The document must ensure that the rights of each secured lender take account of various possible insolvency scenarios, to ensure that reputational and regulatory damage is avoided (see below).
How will the agreement be amended? In particular, are deals struck by individual creditors (as opposed to the full group) capable of entry into the agreement without some manner of ratification being required?
Is the provision of credit conditional upon the taking of certain actions? For instance, the Lender may stipulate that a deposit needs to be paid into an interest bearing account prior to any loan being advanced, or the significant alteration of capital structures (whether by forfeiture, reversal, devaluation or any other form of dilution). The circumstances in which this might occur require careful consideration beforehand to avoid the potential for disputes arising between the creditors.
Are the lenders prepared to wear increasing debt levels in the event of default? Alternatively, are the lenders required to participate in any proposed rescue or "work out" plan? If such a plan fails, the priority in favour of a creditor in respect of a further advance may be at risk.
The enforcement of a secondary credit agreement may involve the release of a debtor from liquidation; qualified consents may be required from all creditors to facilitate the release of a debtor who would otherwise face bankruptcy.
Who pays for the drafting of the agreement? In more sophisticated Intercreditor Agreements, each lender will pay its own legal costs to promote fairness in the process.
There are also risks which relate to the circumstances of any particular intercreditor relationship: Are any of the lenders required to take any action (or avoid any actions) before the release of the security held by any other lender? Lenders may need to consider whether it is acceptable to be held ransom by junior creditors when acting in line with their obligations as senior creditors.
The trade-off between the "junior" and "senior" ranking in secured or unsecured credit agreements should be dealt with in the Intercreditor Agreement. The senior lender may require that, for as long as their loan remains unpaid, the junior lender should not enter into any financial commitment unless such commitment is subordinate to their claim.
Intercreditor Agreements should be relevant to the jurisdiction(s) where the business of the borrower is situated. Such jurisdictional specific arrangements should be in existence prior to, or at the same time as, the commencement of any proceedings in insolvency. Some jurisdictions may have similar arrangements, whilst others may have completely different arrangements in place.
Creditors (and particularly secured creditors) consider intercreditor issues seriously, as they can have a significant impact on the defences available to them, their reputations, their regulatory obligations, their rescue strategies and their profits. Properly drafted intercreditor agreements can address these risks before they become problems.
Enforcement and Other Considerations
The legal enforceability of intercreditor agreements is of particular importance for lenders. In particular, other creditors may not be bound by the intercreditor agreement between the agent and the creditor. Moreover, such agreements may contain provisions or require actions that are subject to regulation by a court or government body, such as the bankruptcy laws. Courts will look to the words of an intercreditor agreement when interpreting its validity and enforceability. The court’s primary concern is ascertaining the mutual intent of the parties. If the language of an agreement is clear and unambiguous, a court will not construct an agreement, nor will it excuse a party from a contractual obligation because the party presumes that the other will perform differently. Courts generally will examine whether the party seeking to avoid performance has substantially and materially breached the contract. This is particularly significant in the context of a dispute over whether an undisclosed creditor or lien holder can assert rights against the secured lender. Furthermore, the interpretation of "control" and "substantially all" may give rise to additional litigation. Courts have also interpreted "no action" clauses to allow a mortgage lender to exercise its discretion with respect to maneuvers where that lender finds itself in control of a debtor’s property.
Parties may contractually limit or prohibit a creditor from taking actions outside the intercreditor agreement. The agreement may limit or prohibit entry into an agreement with a debtor to adjust , refinance or otherwise modify the debt. If there is a material breach of the agreement, the security interest granted to the creditor may be voided. Parties may also agree to submit any dispute to arbitration. However, as long as arbitration is consistent with applicable law, it is generally enforceable. The effect of insolvency on intercreditor agreements is significant. Under the UCC, the perfection of security interests in the collateral of a common debtor by different classes of secured creditors may be subject to avoidance. Courts generally hold that section 544(a) of the United States Bankruptcy Code relieves the lien priority of all creditors. Courts have held that an intercreditor agreement may not provide adequate protection to those creditors if the agreement does not expressly equate priority with enforceability. Intercreditor agreements may contain terms that protect creditors from bankruptcy proceedings by providing that certain transactions are deemed to be indefeasible, even if a debtor later becomes insolvent. For example, intercreditor agreements may prohibit the debtor from preferring one creditor over others, or impose limits on the right of any creditor to enforce or waive its rights. But such provisions must be structured to comply with the Bankruptcy Code.
Recent Trends and Updates
Recent trends and developments in the creation or interpretation of intercreditor agreements are exemplified by decisions released this year by the British Columbia Supreme Court and the Alberta Court of Appeal. In these decisions, the courts considered the applicability of the equitable rule in Dearlove v New Broad Street Syndicate that an agreement affecting real property might, in some circumstances, bind a mortgagee who does not know of the agreement. The agreement in Dearlove was not registered and was therefore not binding at law on the mortgagee. However, because the mortgagee knew or ought to have known of the agreement, it was held to the agreement in equity.
The mortgagee in Dearlove advanced funds to allow the borrower to redevelop property, thereby benefiting from the appreciation of the value of the property. The agreement in question was that, upon a refinancing, the mortgagee would discharge its mortgage in consideration of shares in the company that held the property. The intention of the agreement was that the mortgagee would benefit from any appreciation in the value of the shares that would reflect the appreciation in the value of the property and any increase in the amounts paid by a new lender. The loan from the mortgagee was one of the primary sources of funds for the rehabilitation of the property.
The decision by the British Columbia Supreme Court in Independent Mortgage Brokers v Fully Insured Mortgage Fund sheds light on the threshold that mortgagees must meet in order for the Court to hold that they should be bound by unregistered tri-party agreements in equity. The Court considered the principles codified in the Securities Act, Grant v Torstar Corporation, and the Supreme Court of Canada’s decision in Canson Enterprises Ltd v Boughton, where the written terms of the agreement between two parties were a relevant factor in determining whether an equitable remedy would be granted.
In Independent Mortgage Brokers, the mortgagee argued that it was not bound by the agreement because it was not registered, was not given notice of it and did not consent to it. The Court held that the purpose of registration is to provide official record of an agreement. The agreement itself did not have to be registered. Because the parties had contractually committed to file the necessary documents to register the agreement, and the mortgagee’s solicitor did not advise the mortgagee that registration was required, the mortgagee could not assert that it did not know about the existence of the agreement. The Court held that regardless of its legal obligations to register the agreement, the mortgagee should have made clear to the parties that the agreement would not be binding on it until it was registered.
In Deck v Rednoble, the Alberta Court of Appeal considered the Dearlove rule in the context of interpreting the mortgage priority clause of the tri-party intercreditor agreement in favour of the agent. The appeal involved the interpretation of the words "and any advance made by the Agent", which encompassed funds advanced by the Lender prior to the execution of the intercreditor agreement. The Court stated that for the purposes of its analysis, it was assumed that the loan made by the agent prior to the execution of the intercreditor agreement was done in the agents’ capacity as agent, and not as an independent lender.
As has been the trend in B.C., the Court in Deck v Rednoble held that the Dearlove rule may be available to third parties other than mortgagors, such as borrowers under loan agreements, if the third parties knew or ought to have known about the existence of the agreement. The Court also held that it was irrelevant that the intercreditor agreement did not specify that the Dearlove rule would apply: it followed from the nature of the agreement and principles of agency that the lenders agreed that the agent may take an advance from itself as agent to secure the benefit of the loan.
Conclusions
In conclusion , intercreditor agreements are an important feature of many structured finance transactions. They can achieve a significant degree of risk reduction for creditors of a certain class. They can also set out very clearly the relevant features of the complex and competing relationships that can arise between creditors in a structured finance transaction and create a greater degree of certainty and predictability for the subordinates and those who may seek to acquire their debt.
