Written by Alon Domb
What are intercreditor agreements?
Intercreditor agreements govern the relationship between the various lenders with exposure to a borrower group. They are often heavily negotiated documents, especially as between the senior and mezzanine lenders. Although borrowers will usually be less involved in such negotiations (given that it concerns the rights and obligations that apply as between competing lenders), borrowers will want to ensure that they do not assume any obligations beyond those that they have agreed to assume under the senior and mezzanine finance documents.
The intercreditor agreement ‘contractually’ subordinates amounts owing to the mezzanine lender, so that the senior lender ranks in priority to them. Often this will be reinforced by ‘structural’ subordination, whereby the senior lender lends to those entities which generate operating revenues (e.g. in a real estate finance context, the entites which receive rent), and the mezzanine lender lends to an indirect holding company of those entities. The senior lender (as a holder of debt in the operating entities) ranks ahead of the mezzanine borrower (as a holder of equity in the operating entities) and thus the mezzanine lender is ‘structurally’ subordinated by virtue of where it lends into the borrower group relative to the senior lender.
The intercreditor agreement also sets out the various rights and obligations of the senior and mezzanine lenders, discussed further below.
Have the commercial terms been agreed?
For the lawyers involved in the transaction, it is considerably easier (saving time, and, ultimately, cost) if the parties have already agreed the commercial terms of the intercreditor arrangements prior to the lawyers becoming fully engaged, and these are set out in a clear set of agreed principles which can be used by the lawyers for both drafting and reviewing the intercreditor agreement. The intention of this article is to provide a simple, non-exhaustive list of some of the key issues that the parties ought to consider at this early stage.
Will increases in the senior debt rank ahead of the mezzanine debt?
The senior lender will want to ensure that if it later decides to lend an additional amount to the borrower group, that additional amount will benefit from the senior debt’s first ranking position (and, consequently, rank ahead of the mezzanine debt).
A compromise is often reached through a concept of ‘headroom’, where the additional amount that can benefit from the senior debt’s first ranking position is capped, with any amount lent in excess of this cap ranking behind the mezzanine debt.
The parties will need to consider, firstly, whether a concept of headroom is appropriate for the transaction, secondly, the amount of any such headroom (which is usually between 5 – 10% of the day one senior debt) and, thirdly, what should and should not fall within the headroom concept (e.g. should senior enforcement costs rank as senior debt whether or not within the cap?).
When can payments be made to the mezzanine lender?
The parties will need to agree when the mezzanine lender will be entitled to receive payments, both in the ordinary course of the loan and in a distressed scenario.
Usually, the mezzanine debt can continue to be serviced unless the senior lender takes some action to stop payments being made, which the senior lender will be entitled to do in certain circumstances (e.g. following a failure to pay amounts owed to the senior lender). The senior lender will require this right to ensure that the borrower group retains as much cash as possible to service the senior debt. The senior lender will also want a turnover clause (or clawback provisions) so that it can claim directly against the mezzanine lender if the mezzanine lender receives a payment that it is prohibited from receiving.
The mezzanine lender will want to ensure that there is certainty concerning when such payments may be resumed (e.g. when the event causing it has been remedied or waived? or will the senior lender need to take some positive action and to what extent is this discretionary?). The mezzanine lender will also want to ensure that the borrower group is not released from liability to service the debt as a result of the restrictions imposed by the senior lender, and that there is clarity about what happens to the payments that were previously restricted (e.g. are they capitalised? or are they paid once the restriction ends?).
Can the lenders amend the finance documents?
The mezzanine lender will want to prevent the senior lender amending the terms of the senior finance documents to preserve the economic fundamentals of the original deal and to protect their credit position.
A compromise is often reached to allow the senior lender to generally make amendments without the mezzanine lender’s consent, but prohibiting certain material amendments (e.g. increasing the senior debt, increasing the interest rate, making financial covenants more onerous or adding new events of default) from being made without the mezzanine lender’s consent. The senior lender will similarly want to restrict the mezzanine lender from amending the terms of the mezzanine finance documents, and will also seek to control the circumstances in which material amendments can be made to them.
The parties will need to agree what amendments require consent and whether the requirement to obtain consent should ever be overridden (e.g. should the senior lender need the mezzanine lender’s consent if the mezzanine debt is wholly under water?).
Are there any restrictions on enforcement action taken by the senior lender?
As the senior lender should be paid in priority to the mezzanine lender, it follows that the senior lender should control any enforcement of security. Previously, there were few restrictions on senior lenders taking enforcement action, beyond limited obligations to consult with mezzanine lenders. However, this seems to have changed following the global financial crisis, with mezzanine lenders seeking (and often obtaining) protection against the risk of fire sales that leave them out of the money.
These will often include an obligation on the senior lender to take reasonable care to obtain a fair market price, and may even extend to, amongst other things, a requirement for a particular formal sales process to be undertaken, or for a ‘fairness’ opinion to be obtained confirming that fair value would be obtained as a result of the enforcement sale. The senior lender will clearly want to keep such obligations to a minimum, not least because it will slow down any enforcement action.
Can the mezzanine lender take any enforcement action?
The mezzanine lender will not want to cede complete control over the enforcement process to the senior lender. Firstly, where the mezzanine lender has been structurally subordinated, it will want to be able to enforce any security that has been granted to the mezzanine lender only. Secondly, if for whatever reason the senior lender fails to enforce any common security for a considerable period, the mezzanine lender will want to then be able to enforce the common security, and will often seek a position whereby it is prohibited from enforcing during a ‘standstill’ period, but is free to do so after the expiry of that period. The parties will need to agree when and over what assets the mezzanine lender is able to enforce security including the length of the ‘standstill’ period if there is to be one.
Gordon Dadds acts for senior lenders, mezzanine lenders and borrowers, and has experience advising on intercreditor agreements on all deal sizes.
Thank you to Cassian Goode, solicitor in our Corporate department, for his help in preparing this article.
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After graduating from Manchester University with a BA Hons in Economics, I trained at Saunders Sobell and qualified in 1988. Before joining Gordon Dadds in 2014, I was a partner at Frank Charlesly & Co and head of the corporate department at Davenport Lyons. I have extensive experience in advising on M&A, joint ventures, structured real estate, corporate finance, partnership law and business affairs. Outside of work, I enjoy hiking, visiting the theatre and cinema, and spending time with my family.