Bankruptcy Risks for Second Lienholders

Presenting a live 90-minute webinar with interactive Q&A Bankruptcy Risks for Second Lienholders Overcoming Challenges With Lien Stripping, Sect. 363 Sales, Intercreditor Agreements and More TUESDAY, AUGUST 27, 2013 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Vincent J. Roldan, Vandenberg & Feliu, New York Matthew P. Ward, Partner, Womble Carlyle Sandridge & Rice, Wilmington, Del. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

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Bankruptcy Risks for Second Lienholders August 27, 2013 Vincent J. Roldan vroldan@vanfeliu.com

Benefits of a second lien The second lien holder enjoys all of the rights that the Bankruptcy Code provides to secured creditors. Section 363(e) prohibits the debtor from using, selling, or leasing property subject to a lien, unless the lienholder s interest is adequately protected. Section 361 compensates a secured creditor for the delay associated with bankruptcy, through the concept of adequate protection. Under section 363(f), the debtor cannot sell property free and clear of a lien, unless Non-bankruptcy law permits the sale of such property free and clear of the lien; The lienholder consents; The property is sold for more than the value of lien; The lien is in dispute; and/or The lienholder can be compelled to accept a money satisfaction of the lien. Section 363(k) authorizes a secured creditor to credit bid. 6

Benefits of a second lien (cont d) Separate classification under section 1122, which makes confirming plan of reorganization more difficult. Under Section 1129(b)(2)(A), the debtor cannot confirm a plan over a secured creditor s objection unless the plan is fair and equitable with respect to secured claims, which means: The secured creditors retain their liens in the collateral, and receive in deferred cash payments at least the full value of their secured claims, measured as of the effective date of the claim; This typically means that the plan must provide interest payments to the secured creditors who are compensated through deferred cash payments. If the encumbered property is sold free and clear of liens, such liens attach to the proceeds of the sale; or The secured creditor will receive the indubitable equivalent of its claim. 7

Intercreditor agreements Effectively limits the rights that the second lien holders enjoy as secured creditors, by subordinating their liens to the senior lien holders. Section 510(a) of the Bankruptcy Code provides that subordination agreements are enforceable to the same extent that such agreement is enforceable under applicable non-bankruptcy law. 8

Intercreditor agreements (cont d) Common provisions Lift stay waiver advance waiver of the second lien holder of its right to contest a motion by the first lien holder for relief from the automatic stay; Voting rights/plan support allowing the first lien holder to vote the second lien holder s claim, or requiring that the second lien holder will not support a plan opposed by the senior lender; Asset sales advance consent by the second lien holder to any asset sale under section 363 of the Bankruptcy Code that is supported by the senior lender; Adequate protection prohibiting the second lien holder from seeking adequate protection of its interest in common collateral until the senior lender has received adequate protection of its interest; DIP financing/cash collateral advance consent by second lien holder to the priming of its liens by any DIP financing provided by the senior lender, and advance consent to any use of cash collateral approved by the first lien holder; Exercise of remedies prohibiting the junior lender from exercising any remedies against the common collateral; Challenge rights prohibiting the second lien holder from challenging the validity or priority of the first lien. ABA Model Intercreditor Agreement can be found at www.abanet.org/dch/committee.cfm?com=cl190029 9

Intercreditor agreements (cont d) Key cases Beatrice Foods Co. v. Hart Ski Mfg. Co., Inc. (In re Hart Ski Mfg. Co., Inc.), 5 B.R. 734 (Bankr. D. Minn. 1980) (Advance waiver of rights to contest senior lender s lift stay motion, or right to seek adequate protection, are unenforceable). The Bankruptcy Code guarantees each secured creditor certain rights [such as] the right to assert and prove its claim, the right to seek court-ordered protection for its security, the right to have a stay lifted under proper circumstances, the right to participate in voting for confirmation or rejection of any plan of reorganization, the right to object to confirmation, and the right to file a plan where applicable. The above rights and others are not related to contract priority of distribution pursuant to Section 510(a) and cannot be affected by the actions of the parties prior to the commencement of a bankruptcy case when such rights did not even exist. Bank of America, N.A. v. N. LaSalle St. Ltd P ship (In re 203 N. LaSalle St. P ship), 246 B.R. 325, 331 (Bankr. N.D. Ill. 2010) (holding that provision allowing the first lien holder to vote the subordinated claim was unenforceable; reasoning that section 510(a) affects the priority of claims, but not the transfer of voting rights). In re Aerosol Packaging, LLC, 362 B.R. 43 (Bankr. N.D. Ga. 2006) (rejects 203 N. LaSalle, upholds a provision in a subordination agreement allowing a senior lender to vote the junior lender s claim). 10

Intercreditor agreements (cont d) Key cases In re Ion Media Networks, Inc., 419 B.R. 585 (Bankr. S.D.N.Y. 2009) (denied standing to a second lien creditor seeking to challenge a plan of reorganization; plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and creditor expectations should be appropriately fulfilled. ). In re Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D. Tex. 2010) (finding that subordination agreement prohibited the subordinated creditors from seeking enforcement of an examiner, because doing so was the taking of an action to seek to enforce remedies and to pursue collection of their claims, without consent of the agent). In re Boston Generating, LLC, 2010 WL 4922578 (Bankr. S.D.N.Y. 2010) (allowing second lien holders to object to bid procedures motion because the intercreditor agreement did not specifically restrict that action). 11

In re Heritage Highgate, Inc. 679 F.3d 132 (3d Cir. 2012) The players Debtor owned a mixed-use residential subdivision, planned for 411 units. 101 units constructed and delivered as of the petition date. Debtor had an appraisal establishing a FMV of $15 million for the project, just prior to the petition date. First lien $16.5 million, secured by substantially all of the debtor s assets. Second lien $1.4 million, secured by a second lien on substantially all of the debtor s assets. 12

Bankruptcy Code Section 506(a) An allowed claim of a creditor secured by a lien on property in which the estate has an interest is a secured claim to the extent of the value of such creditor s interest in the estate s interest in such property and is an unsecured claim to the extent that the value of such creditor s interest. is less than the amount of such allowed claim. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor s interest. 13

Standard for valuing claims Burden of Proof Some courts hold that the secured creditor bears the burden of proof. See In re Sneijder, 407 B.R. 46, 55 (Bankr. S.D.N.Y. 2009). Other courts hold that the party challenging the value (usually the debtor) bears the burden of proof. See In re Weichey, 405 B.R. 158, 164 (Bankr. W.D. Pa. 2009). Third method (ultimately adopted by Heritage Highgate): debtor bears the initial burden of proof to overcome the presumed validity and amount of the second creditor s claim, but the ultimate burden of persuasion is upon the creditor to demonstrate by a preponderance of the evidence, both the extent of its lien and the value of the collateral securing its claim. In re Robertson 135 B.R. 356, 352 (Bankr. E.D. Ark. 1992). 14

Standard for valuing claims (cont d) Section 506(a) does not specify the appropriate valuation standard. See In re Winthrop Old Farm Nurseries, Inc., 50 F.3d 72, 73-74 (1st Cir. 1995). Value does not necessarily mean liquidation, value, forced sale value, or a full going concern value. Rather, Congress envisioned a flexible approach whereby courts choose the standard that best fits the circumstances of a particular case. Heritage Highgate, 679 F.3d at 141 (citing H.R. Rep. No 95-595, at 356 (1977) reprinted in 1978 U.S.C.C.A.N. 5787, 6311). Heritage Highgate rules, the appropriate standard for valuing collateral must depend upon what is to be done with the property whether it is to be liquidated, surrendered, or retained by the debtor. E.g., if the debtor intends to use collateral to generate income with which to pay creditors, a valuation based on a hypothetical foreclosure sale would be inappropriate. Instead, the collateral s fair market value is preferable. Bankruptcy courts will determine the appropriate time as of which to value the collateral. Heritage Highgate rejected the second lien holders use of projections attached to the plan in order to determine value as of confirmation. Instead, valuation must be based on realistic measures of present worth. 15

Lien Stripping Dewsnup v. Timm, 502 U.S. 410 (1992) Chapter 7 case. Rejected the notion that a mortgagee could be forced to accept a judicially determined value, if at a later time a foreclosure sale produces more. Court was guided by the principle that liens pass through bankruptcy unaffected. Majority of courts analyzing the issue in the context of Chapter 11 limit Dewsnup to Chapter 7 cases. The distinction is, Chapter 11 involves the retention of property in a debtor s rehabilitation. Pre bankruptcy code law provided for the modification of liens in reorganization cases. Heritage Highgate found section 1129(b), which provides for the retention of liens only up to the value of the secured creditor s claim for purposes of cram down, as indicative of a chapter 11 debtor s ability to strip liens. Also, the Heritage Highgate court found support in section 1111(b), which allows an undersecured creditor to be treated as fully secured to the extent of their allowed claims, which suggests that Chapter 11 debtors have the authority to limit secured claims to the value of their collateral. 16

Heritage Highgate take-aways Importance of presentation of evidence in support of valuation Importance of creditors committee taking an active role 17

Heritage Highgate Unanswered questions Would Heritage Highgate have applied Dewsnup -----if the plan was a plan of liquidation outside the ordinary course of business? What happened to the value of the second lien? Did it erode? Sign of lack of adequate protection Possible super priority claim for erosion of collateral or lack of adequate protection. What if the second lienholders presented evidence to rebut the appraisal used by the committee? The second lien holders declined to present their own appraisal, but instead relied on the plan budget. 18

Sale Issues When Second Liens Are Involved in a Bankruptcy Case Matthew P. Ward maward@wcsr.com (302) 252-4338 Wilmington, DE August 27, 2013 19

Bankruptcy Code section 363(e) 20

Bankruptcy Code section 363(e): Prohibits use of encumbered property without adequate protection 21

Bankruptcy Code section 363(e): Prohibits use of encumbered property without adequate protection States: (e) Notwithstanding any other provision of this section, at any time, on request of an entity that has an interest in property used, sold, or leased, or proposed to be used, sold, or leased, by the trustee, the court, with or without a hearing, shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.... Further provides that property subject to personal property lease is not subject to relief from automatic stay 23

Bankruptcy Code section 363(f) 25

Bankruptcy Code section 363(f): Governs sales free and clear 26

Bankruptcy Code section 363(f): Governs sales free and clear States: (f) The trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if (1) applicable nonbankruptcy law permits sale of such property free and clear of such interest; (2) such entity consents; (3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property; 30

Bankruptcy Code section 363(f): Governs sales free and clear May apply to second liens where second liens are out of the money and do not consent 33

Bankruptcy Code section 363(f): Governs sales free and clear May apply to second liens where second liens are out of the money and do not consent 9th circuit: Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (B.A.P. 9th Cir. 2008) New York: In re Becker Indus. Corp., 63 B.R. 474 (S.D.N.Y. 1985) New York: In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010) Delaware: In re Kellstrom Indus., Inc., 282 B.R. 787 (MFW) (Bankr. D. Del. 2002) Delaware: Sale Order, In re Cyber-Defender Corp., Case No. 12-10633 (BLS) (Docket No. 192) (Bankr. D. Del. May 7, 2012) 38

Bankruptcy Code section 363(f): Governs sales free and clear May apply to second liens where second liens are out of the money and do not consent Sale of assets to junior lienholder (e.g., Contrarian Funds LLC v. Aretex LLC (In re WestPoint Stevens, Inc.), 600 F.3d 231 (2d Cir. 2010)) 40

Bankruptcy Code section 363(k) 41

Bankruptcy Code section 363(k): Governs right to credit bid 42

Bankruptcy Code section 363(k): Governs right to credit bid States: (k) At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property. 43

Standing of second lien creditors to object to section 363 sale 45

Standing of second lien creditors to object to section 363 sale In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010) 46

Standing of second lien creditors to object to section 363 sale In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010) Purchaser s Brief, In re Cyber-Defender Corp., Case No. 12-10633 (BLS) (Docket No. 166) (Bankr. D. Del. April 30, 2012) 47

Role of Unsecured Creditors Committee 48

Role of Unsecured Creditors Committee Often, a second lien will hold the fulcrum security, and the committee might seek to have such debt converted to equity 49

Role of Unsecured Creditors Committee Often, a second lien will hold the fulcrum security, and the committee might seek to have such debt converted to equity Ability to charge the secured lender for expenses necessary to preserve the secured lender s collateral under section 506(c) Unless the debtor has unencumbered assets (e.g., chapter 5 avoidance actions), unsecured creditors will have a limited economic stake in the case 51