The overheated debt markets from 2003 to 2007 resulted in a record volume of buyout transactions by financial sponsors. The proliferation of second lien debt provided by hedge funds, private equity funds and other nontraditional investment vehicles like collateralized loan obligations satisfied the demand for leveraged debt created by these acquisitions. In contrast to traditional mezzanine indebtedness, second lien debt was less expensive and did not dilute the sponsor’s equity ownership. In the current post-credit freeze era, second lien financing is disappearing, and mezzanine and other subordinated debt options are reemerging to fill the gap between senior loans and equity with a wide range of intercreditor and subordination terms. This article will discuss the importance of clearly defining these terms early in the process.
As the credit freeze begins to show signs of thawing, private equity groups and strategic acquirers looking to close buyout loans should expect banks and other lenders to approach these transactions with a “back to basics” mentality. An article in the October 9, 2009, edition of The Wall Street Journal entitled, “In Today’s LBO Arena, Much Sweat, More Equity,” provided recent examples of the more conservative capital structure mandated by senior lenders. Another area in which senior lenders’ renewed preoccupation with fundamentals has manifested itself is intercreditor agreements. By entering into an intercreditor agreement with appropriate standstill, payment blockage, turnover and other key provisions, senior lenders and private equity groups may be able to avoid an unwelcome surprise in the form of a junior lender with the ability to disrupt workout negotiations at a later date.
Types of Subordination
Debt subordination refers to the agreement by a subordinated lender to defer payment of some or all of its claims until the senior loans are paid in full. A partial debt subordination would usually permit a subordinated lender to receive some or all of its scheduled payments in the absence of an event of default under the senior credit facility. A complete debt subordination means that the subordinated lender would not receive any payment on its loans until the senior lender received payment in full on its senior loans. A senior lender might require this type of subordination in a buyout transaction in which a portion of the purchase price is in the form of a note payable to the sellers in order to reduce the amount of cash necessary at closing to complete the acquisition. Second lien loans generally contained limited debt subordination provisions that were only triggered by collection actions. In contrast, current transactions involving mezzanine and other institutional subordinated debt typically provide the senior lender with the ability to implement a payment blockage against the subordinated lender for a specified period of time (generally set in the range of 90 to 180 days) for an event of default that does not involve the failure to make a payment on senior debt, and a permanent payment blockage for a default due to failure to pay all or any portion of the senior debt.
Lien subordination means that one lender agrees that the priority of its liens on property that serves as common collateral will be subordinate to the liens of another lender. Subordinated secured lenders possess certain rights because of their status as lienholders that, in the absence of an agreement to the contrary, would interfere with the rights of senior lenders in workouts or bankruptcies. A typical lien subordination enables the senior lender to collect on the proceeds of its collateral before the subordinated lender, and the subordinated lender will agree to some short period of time before taking any foreclosure action against shared collateral. This is called a “remedy standstill” provision. The senior lender expects to be in the driver’s seat for a period of time (i.e., a range of 90 to 180 days) when it comes to dealing with, and exercising remedies against, the shared collateral. The generally accepted principle is that the subordinated lender should be permitted to exercise remedies in the event that the senior lender fails to commence an exercise of its remedies after this standstill period. Acquirers may want to move forward with documentation based on their lenders’ mutual agreement that the second lien will be a “silent second” or that it will be “deeply” subordinated, but they do so at their peril. The meaning of both of those terms will vary from one deal to the next based upon numerous factors, including the composition of the senior and subordinated lender groups, the difficulty of syndicating those loans, the nature and value of the collateral for those loans, and the relative size of those loans. A deal can be delayed or sidetracked because of the lenders’ failure to agree on what each side meant by the use of those terms.
Remedies standstill provisions will normally be accompanied by terms that require the subordinated lender to turn over any amounts that it may recover in a liquidation or bankruptcy to the senior lender. This type of “turnover clause” is intended to prevent a subordinated lender from receiving more than it would have been entitled to receive under the intercreditor agreement. Turnover provisions involve drafting nuances that may fundamentally modify their effect. For example, if the intercreditor agreement were to permit the subordinated lender to foreclose at the end of the remedies standstill period, then the drafting of the turnover provision might permit a subordinated lender to argue that it should not be obligated to turn over to the senior lender any funds that it received following the end of the standstill period.
Structural subordination is a device frequently encountered in transactions involving mezzanine and other types of subordinated debt. Structural subordination means that the priority of payment of an obligation as a practical matter is determined by the structure of the financing transaction and the recipient of the loan rather than by any express contractual agreement by a lender to subordinate its priority. In the standard structurally subordinated financing, the senior lender would make a loan to the operating company that owns the assets that serve as collateral for its loan, while the obligor of the mezzanine lender’s loan would be a holding company that owns no assets other than the stock that it holds in the operating company.
In the current environment, one should expect that senior lenders will insist on structures that maintain the sanctity and protection of a deep subordination. At the same time, mezzanine and other subordinated lenders will be looking for better pricing, an opportunity for supplemental equity returns and greater rights than second lien lenders accepted during the frenzied credit environment that permeated from 2003 to 2007. Because of the conflicting goals of these two classes of lenders, a private equity group or other acquirer should convince its lenders to address intercreditor issues at an early stage in the deal negotiations in order to avoid potentially lengthy and costly delays when that deal is otherwise on the verge of consummation.
Effective September 1, 2009, Title 15 of Article 5 of New York State’s General Obligations Law (NYGOL) was amended, creating significant changes to New York’s power of attorney law. The new law applies to every power of attorney executed in New York by an individual after September 1, 2009. The NYGOL defines power of attorney as “a written document by which a principal with capacity designates an agent to act on his or her behalf.” The new law, with its broad language and absence of exceptions, appears applicable not only to powers of attorney in personal financial, tax and estate planning contexts, but also those created in business and commercial contexts.
Powers of attorney may be contained within purchase and sale, merger, partnership and joint venture agreements; bank loans; proxies used by public companies in elections of directors; and other similar business arrangements. In the business context, though, powers of attorney are not always labeled as such, but include authorizing one person to do something on behalf of another, such as filing documents with state agencies or paying taxes and other charges.
The operative provision of Section 5-1501B of the NYGOL provides that to be valid, a statutory short form power of attorney, or a non-statutory power of attorney, executed in New York by an individual, must adhere to the following guidelines:
Be typed or printed using at least 12 point sized letters, or, if in writing, a reasonable equivalent
Be signed and dated by the principal, with the signature of the principal duly notarized
Be signed and dated by any agent acting on behalf of the principal, with the signature of the agent duly notarized
Include the exact wording of the: (1) “Caution to the Principal” in paragraph (a) of subdivision one of Section 5-1513 of Title 15 of the NYGOL and (2) “Important Information for the Agent” in paragraph (n) of subdivision one of Section 5-1513 of Title 15 of the NYGOL
The new legal requirements impose new burdens in the commercial and transactional context. For example, the required cautionary language set forth in the “Caution to the Principal” and the “Important Information for the Agent” is extensive, and the exact wording of the statute must be included. As a result, the required language will significantly lengthen any power of attorney provision incorporated in a larger transaction document. In addition, the requirement for a notary public for both the principal and the agent can be impracticable and burdensome and cause unnecessary delay in the transactional context.
Parties may consider including the power of attorney in a separate document. A separate power of attorney has the procedural benefit of being able to be signed separately, pending the negotiation of the transaction documents, and the drafting benefit of separating out a lengthy power of attorney from the transaction documents. A separate power of attorney may also contain any challenges to validity of the power of attorney for noncompliance to the separate power of attorney.
While the new law does not affect powers of attorney executed prior to September 1, 2009, those powers of attorney executed by an individual after September 1, 2009, will revoke all prior powers of attorney (including those that are unrelated) executed by such individual, unless the new power of attorney expressly states otherwise. To avoid this potential pitfall created by the new law, future powers of attorney executed by an individual principal in New York should contain protective language (unless such principal intends otherwise). Express language should be included to make clear that such power of attorney does not revoke in whole or in part any power of attorney that such principal previously executed, and further, that such power of attorney shall not be revoked by any subsequent power of attorney that such principal may execute, unless such subsequent power of attorney expressly indicates that it is intended to revoke all prior powers of attorney.
The limitations on routine commercial transactions that have resulted from the general application of this new law are expected to be addressed by the New York legislature in January 2010. The initial technical corrections act, which was passed by the New York State Assembly but not the New York State Senate, is currently being revised to address certain defects that were observed by the New York State Law Revision Commission. In the meantime, though, the new law applies to all powers of attorney executed by individuals in New York on or after September 1, 2009, and counsel must draft and plan accordingly.
Adam Lelonek was also a principal author of this article.