Intercreditor issues in complex financings of joint ventures
By Denis Petkovic
Intercreditor arrangements have always been a feature of secured lending and structured finance, but the relationships and accommodations among lenders have become more important with the growing diversity of capital providers.
There has been an explosive growth in the project finance market in hedge fund activity as these funds participate as lenders under a “second lien financing” or “term B loan.” Both terms describe financings that are essentially secured junior debt. Emerging market funds, distressed debt funds and other non-bank financial intermediaries have also been stepping in to provide different layers of capital to projects. The upshot of this is an increasing concern in project documents about investor exit, capital and debt layering and intercreditor terms.
This article covers two topics. The first part of the article discusses issues that should be addressed in joint ventures to undertake projects and emphasizes the impact that admit- ting fund investors has on joint venture documents. The second part addresses some of the new challenges posed by increasingly complex intercreditor relationships.
Joint Venture Structures
There are certain basic structuring aspects to consider when setting up a joint venture to undertake a project.
Choice of project entity is probably the first big issue. One may choose to use an incorporated entity for the joint venture in order to insulate the sponsor and investors from personal liability to creditors of the project company. However, a partnership often has more appeal. The main benefit of using a partnership is that it is usually transparent for income tax purposes. There is no income tax at the entity level; the partners are taxed directly on their shares of income. The risks associated with fiduciary duties owed by one partner to the other can be minimized by using companies as partners and tightly regulating what such entities may do in a joint venture agreement.
Unincorporated or contractual joint ventures are also popular in some industries and in some countries — for example, in the mining sector. Their essential element is that each joint venturer is entitled to (and can take in kind) its share of product derived from the project. Unincorporated joint ventures are similar to partnerships in many respects, but are nevertheless considered to be a different legal creature. Each venturer generates a separate profit, maintains separate accounting, obtains separate tax treat- ment and appoints a separate manager as its agent. This suggests that separate businesses are operated. A guiding principle of such joint ventures is that expenses are shared, but revenues are not. Expenses are funded by cash calls in agreed proportions. In addition, parties hold joint venture assets as tenants in common, pay expenses proportionately and appoint a manager to run the joint venture. Default by a joint venturer will usually result in dilution of the defaulting party’s interest or the granting of cross-security to the other party that can be enforced on default.
If a local concession is held by a project company or operator, then it may be sensible to insulate the concession- holding company from shareholder disputes and changes in control by putting the concession into a subsidiary company. If cross-border withholding taxes will apply to dividends or interest then, if possible, one should try to invest into the project company from a jurisdiction with a favorable tax treaty. Investors may want to invest through one or two layers of companies to enable them to exit the project by disposing of an intermediate company rather than the direct interests in the project for political, regulatory or tax reasons.
Another important issue concerns the structure of the managing board and the degree of control that will be exercised by investors. The composition of the board of directors will usually reflect the size of the parties’ respective interests in the company. Where ownership is equally divided between two owners, board representation will also usually be equal. In such cases, the parties must decide what role the chairman of the board will have and how deadlocks on urgent matters will be resolved. Other important governance matters are who to appoint as directors, how board decisions will be made, what constitutes a quorum, the exact voting rights of directors, and who will handle legal compliance, budgets, reporting and health and safety matters.
While issues of relative shareholder control are matters for negotiation among the parties, project lenders and sponsors should be alert to the laws in the jurisdiction where the project company is located, laws that may operate to give default powers or protections to majority or minority holdings. For example, under English law, a shareholding of 26% is strategically important because it permits the blocking of special and extraordinary resolutions. Other rights or protections apply under English law to shareholders owning 95%, 75%, 51%, 15% and 10% of equity. In some jurisdictions, default legal rights or protections may be overridden by express contrary contractual provisions.
Another issue is what actions are so important as to require the consent of the minority shareholders or owners. Typically, the agreement of all owners is required in order to approve a business plan, incur material expenditures not on the approved business plan, change the company’s constitutional documents, legal forms or share structure, including the issuance of shares, incur any loan or give any guarantee, indemnity or security not envisioned by the business plan, transfer all or any material part of the company’s assets, appoint or dismiss key personnel, change auditors or acquire or dispose of equity in another company.
Where the parties have agreed that specific matters require unanimous approval of the shareholders or directors and there is a failure to obtain any such approval, a deadlock results. It is extremely important to include in a shareholders agreement the means by which such a deadlock may be broken. Financiers will insist on some means to break the deadlock.
One common mechanism is for the organizational agreement to provide for the adjournment of the board or other meeting at which the deadlock has arisen for a period of 30 days, and if after that period a resolution is not found the company is to be wound up. This is a draconian result that serves as a strong commercial incentive for the parties to resolve their differences. Or, alternatively, the dispute can first be referred to an outside “swing man” director, who only acts as a director when there is a deadlock.
Another way to resolve deadlocks is for each party to have the right to exercise cross-”call” and “put” options upon the happening of a deadlock. This is often called “Russian roulette.” One party is permitted to serve notice on the other either to sell his shares to the other or to buy the other’s shares at the same price. The party receiving the notice then has the choice of either buying or selling, but if he fails to make a choice, the party serving the notice can require the other to buy or sell his shares at the price in the original notice. As the price must be one at which the party serving the notice is prepared to both buy and sell, it usually follows that a fair price is chosen. The arrangement works well if both parties have or can raise the resources to buy out the other. It is capable of being abused when one of the parties to the joint venture knows that the other does not have the resources to cope with service of such a notice.
Rights of preemption are very important in most joint ventures. Typically, shareholder agreements provide that any shareholder who wishes to transfer his shares will first have to offer them to the other shareholders at the offer price or a price set by the company’s auditors. If the shares are not taken up by the other shareholders, then they usually may be sold freely to third parties. In some cases, it may be prudent to include an initial period during which voluntary transfers are absolutely prohibited, emphasizing the shareholders’ commitment to the joint venture for at least a particular period — the “lock-up period.” Common exceptions to the lock-up period include permitted transfers to affiliates or to existing unrelated shareholders.
The joint venture agreement should discuss how to handle the default by a shareholder. Shareholder default could result from the shareholder’s failure to meet a cash call or its experience of an event specified in the agreement, like bankruptcy. During a period of default, the defaulting share- holder should be blocked from exercising voting rights except, perhaps, where a matter would increase its own financial commitments. However, blocking voting on matters pertaining to transfer of shares, assignments of shareholder loans and receipt of dividends can be contentious issues.
Different consequences can flow from different events of default. If a payment default occurs (which could include an initial subscription of capital) and other shareholders step in to pay the cash call, dilution of the non-payer could follow according to a formula such that the proportion of shares to be sold to the non-defaulting investor has a correlation to the proportion of defaulted debt. If a willful default in respect of shareholder obligations occurs, then voting rights may be blocked and executive committee nominees of the defaulting shareholder may be precluded from acting. If a bankruptcy event occurs, then a buy-out procedure may be activated at the fair market value or other value of the shares. In such a case, the shareholder may be treated as having offered all of its shares to the other shareholders pro rata — not necessarily at a fair market value, but perhaps at par or some discounted price reflecting that the shareholder is being penalized due to default.
The involvement of a financial investor such as a fund that is particularly interested in exit and returns on exit will cause special provisions to be included in a joint venture agreement. First, the agreement will probably require a lock- up period that lasts until project completion and during which no share transfers may be made by key sponsors. Second, in the event of a default by a key sponsor, the fund will likely be entitled to “put” its interest to a third party without activating the preemption rights of other investors. Third, it is typical to see “tag-along rights” in these agreements — whereby all shareholders are entitled to sell their shares at fair market value if the sponsor or financial investor has this right — or “drag-along rights” that require a party to make the same offer to purchase shares to all shareholders if it makes the offer to any shareholder. Lastly, often a financial investor will insist that the agreement prescribe when a public listing must take place and what the mutual obligations of the shareholders are at that time. Invariably, the financial investor will wish to control the listing process.
Another important item is planning for dispute resolution. If court judgments from one jurisdiction will not be enforceable in another, then the agreement should provide for arbitration and ensure that any arbitration award will be enforceable in all relevant jurisdictions or as desired. Also, where a party to the joint venture is a government or governmental instrumentality (not always easily deter- mined), nongovernmental parties should be sure to get waivers of sovereign immunity.
Complexity Tied to Mezzanine Debt
There is an increasing complexity in the layering of capital and the intercreditor arrangements involved in project joint ventures. This increased complexity results from the growing use of mezzanine financing.
Mezzanine financing is often the final layer of debt in an acquisition financing and, increasingly, an important layer in project finance.
“Mezzanine finance” describes a range of financing arrangements, including second-lien financings, term B loans and the issuance of high-yield bonds. It is a mid-level or hybrid financing somewhere between higher-grade debt and equity. Economically, it can perform in the same way as equity while legally constituting debt (or vice versa). This type of financing carries a higher risk and a higher rate of interest or yield than senior secured commercial bank term loans, and historically has involved fixed-rate, seven- to 10- year financings. Mezzanine debt is junior to other debt, generally meaning that it is unsecured or subordinated or both and, increasingly, subject to intercreditor priority ranking arrangements.
Mezzanine debt such as “high-yield bonds” has tradition- ally been long term, fixed rate and less intrusive in terms of covenant control than commercial bank debt. Cash flow control ratios such as interest rate coverage ratios have been uncommon. Such finance also typically contains a call option entitling the borrower to call in the bonds early and repay the outstanding indebtedness. Mezzanine finance can be arranged in the public markets or privately through private placements to sophisticated investors and lenders.
In recent years, however, mezzanine with other characteristics has become more prevalent and known as “second-lien financings” or “term B loans.” Second-lien financings are generally bond transactions utilizing a priority arrangement between senior secured creditors and junior creditors; term B loans are a similar animal financed mainly in the bank market rather than the bond market.
In understanding the legal tools used to construct mezzanine finance, there are four key legal concepts to appreciate. They are subordination arrangements, priorities arrangements, preference shares and convertible notes. Interconnected with most of these topics (although less so with preference shares) is the issue of intercreditor arrangements. Indeed, subordination and priorities arrangements are intercreditor arrangements in their own right.
Where two unsecured creditors (or creditors sharing the same security) agree that in the winding up of a borrower, one creditor will rank behind all or certain other debts of the company, such an arrangement is known as subordination and the various categories of creditors, often with the company, enter into a subordination deed or agreement to document that arrangement and to regulate pre-insolvency credit arrangements.
One method of achieving subordination is structural subordination. A senior lender can achieve subordination without a junior creditor contractually giving up any rights, by restricting the recourse the junior creditor has to obligations and assets of particular companies in a group. Such a structural subordination is still sometimes a feature of trans- actions involving second-lien financings and term B loans leading, in the view of some lawyers, to complexity and confusion in structuring.
Structural subordination involves, for example, an interim or other holding company of a borrower issuing high-yield debt to investors or lenders and relending the proceeds to an operating or project company. Senior lenders, however, will lend to the subsidiary project company on a secured basis. Upon insolvency of the project company, the high-yield bondholders will not be creditors of the operating company and are unlikely to recover anything after the subsidiary’s secured creditors are satisfied. If guarantees are issued by an operating company to the high-yield bondholders, they are likely to be subordinated to the senior debt being incurred at the operating company level.
Subordination can also be contractual. It may be achieved by a simple contractual undertaking under English law. Governing law should be checked to be sure that this contract term will be respected.
The junior creditor may also agree with a senior creditor that any dividend received in respect of a claim in a winding up of the debtor company or any other amount received will be held in trust for the senior creditor to the extent of its debt.
Lastly, the senior creditor could seek an assignment of the junior creditor’s loan or take a charge over the rights of the junior creditor against the borrower. Obviously, if there are restrictions on the junior creditor’s ability to assign its loan, contractual subordination could be used instead of an assignment. Note that unlike contractual subordination, an assignment agreement will not necessarily terminate on repayment of the senior creditors’ debts and may also be subject to registration as a security under local law.
Any of the above methods should be effective in the insolvency of the debtor company or the junior creditor to achieve the junior ranking of a junior creditor’s indebtedness. Quite often, several of these methods can be used in tandem.
Under English law, “priorities arrangements” have traditionally applied to categories of secured debt and are usually the subject of a “deed of priorities” between two secured creditors under which they agree that one creditor’s security shall have priority over another’s. This means that on disposition of the security, proceeds will be applied first to satisfy the indebtedness of the senior creditor and only next to satisfy the indebtedness of the junior creditor.
Historically, the purpose of an English law priorities deed was to fix priorities over the same asset, usually by altering the default priorities that applied under law. Now with second-lien financings and term B loans, traditional provisions in priorities deeds are being incorporated into inter- creditor arrangements that include wider and more extensive clauses defining the commercial obligations and rights of junior and senior creditors.
Under English law, the borrower does not need to be a party to intercreditor agreements in order for them to be valid. If a borrower wants to prevent its secured creditors from rearranging their respective priorities, restrictions to such effect should be included in its loan documents.
An arrangement that does not alter priorities, but that deals with sharing of realization proceeds, is often called a sharing or pro-rata sharing arrangement.
Many hedge funds are precluded from investing in subordinated debt and are forced to consider secured second-lien debt documented by intercreditor agreements. Unlike subordinated debt, such secured second-lien debt qualifies as “senior secured debt,” providing priority over the interests of trade creditors and other unsecured creditors. In the US and in some other jurisdictions, secured second-lien debt gives priority over unsecured liabilities of an environmental nature. Also, a secured junior creditor has a more comfort- able collateral position in negotiations during a work out, which has increased the popularity of this type of financing.
For the borrower, the interest expense on mezzanine debt is generally tax deductible and repayment is easier to effect than it would have been if preferred equity had been issued instead. Also, payout of interest for the investors is, as a legal matter, certain whereas payment of dividends is not.
Senior creditors often object to a secured second-lien deal as they do not want collateral shared with a junior lender, and they do they want any practical interference in managing collateral. However, this is sometimes the only way to finance the project.
There is a view among some market analysts, however, that too much debt is being imposed on companies with the result that deals that would otherwise not get done are being undertaken, potentially jeopardizing the market over the long term. The alternative argument is that there is a market for mezzanine debt and that many investors are willing to accept its higher risk for a higher return.
Senior lenders (including multilateral lending agencies) and sponsors should approach transactions with the knowledge that the terrain has changed since 2003, at least in Europe. In that year, high-yield investors boycotted the leveraged buyout of LeGrand SA, an electronics equipment supplier in France, and increased the pricing on the deal by 100 to 150 basis points in order to have it close. Since then, most larger European leveraged transactions have been structured so as to allow more rights in collateral to junior creditors. Pricing of deals is often in the range of 5% to 6.5% above LIBOR, and equity kickers in the form of warrants may become more of a major feature. The term of the junior debt usually follows the maturity for the senior debt.
The following is a list of provisions that are usually found in intercreditor agreements for a second lien financing or term B loan.
Payments. Interest payments on junior debt are payable on a pari passu basis with senior debt for as long as the senior debt is performing, meaning that no outstanding payment default has occurred on the senior debt and no “stop notice” is outstanding. Principal payments on junior debt should be prohibited or limited until the senior debt is repaid. Second-lien and term B financings are thus not, strictly speaking, junior in debt priority to senior debt where senior debt is performing.
Lien priority. Collateral subject to security interests in favor of the senior lender and junior lender will be subject, generally, to exclusive priority in favor of the senior lender. Until the senior creditor is fully repaid, all proceeds derived from such shared security are applied to the senior debt. The terms of the two creditors’ securities should be virtually identical to minimize documentation mismatch.
Payment blockage. If the borrower defaults, then the senior lender will have payment blocking rights activated. A typical provision may be that on any covenant default, the senior lender may serve a stop notice following which payments to the junior creditor may be blocked for approximately six months so that the borrower and senior lender may rectify any problem. Likewise, a payment blockage will be activated for so long as there is a payment default on the senior debt, in which case no payments to the junior creditor can be made. Moreover, if there is not a payment default on the senior debt, but there is a payment default on the junior debt, then the senior lenders may require financial tests to be satisfied in the intercreditor agreement for a payment to be made to the junior creditor. Such a financial test may be higher than those required to be satisfied in the borrower’s loan documents.
Enforcement standstill. What is the length of time the second lien holder is subject to enforcement standstill on its security after it serves notice of default on the junior creditor? In Europe in the case of a payment default, the standstill typically runs for 90 days. For a less serious financial covenant default, it runs for 120 days and for a less serious default still on some other covenant, the standstill runs for 150 days. In some deals, there may be a correlation between the standstill times and the payment blockage times. In the US, an absolute bar on the junior creditor’s rights to enforce collateral typically prevails whereas no bar applies to rights unconnected with collateral (for example, increased covenant protection or insisting on information to be supplied). Also, standstill provisions should terminate when the senior lender enforces its security interests.
In the United States, it is common to have separate security trustees looking after the rights of second lien holders and the rights of senior debt holders because of perceived conflicts of interest. This is less of an issue in practice in Europe; under English law, fiduciary duties operate to protect the interests of all beneficiaries for whom collateral is held by a security agent or trustee, although there have been exceptions to this practice. Purchase of senior debt. What rights do junior creditors have to purchase senior debt? In Europe, they may have a right to buy out the senior debt for a period of 60 days following enforcement by the senior creditor of its lien (at par plus accrued interest). This is not really a feature of US practice.
A “silent lien.” As mentioned above, it is typical that the junior debt is subordinate to the senior debt insofar as the collateral is concerned. This is a generally accepted principle reflected in the expression that the second lien is “silent” to the interests of the senior lenders. A matter of negotiation is how “silent” the junior debt should be. Some junior lenders will try to obtain a first ranking security interest on limited collateral and a second ranking security interest on other collateral.
Elements of a “silent lien.” A senior lender would typically require that an intercreditor agreement at least contain the following elements of a silent lien. First, the junior creditor will not challenge the validity of the senior lender’s security or its priority. Second, on a release of the senior lender’s collateral, the junior creditor will release its security interest. Third, the senior lender will have exclusive rights to deal with secured assets prior to any standstill period ending in respect of the junior creditor’s security. Fourth, trust obligations will be imposed on the junior creditor for mistaken payments and unauthorized receipts backed up by an obligation to “turn over” or pay the same to the senior lender.
Amendments. Junior creditors are very concerned with amendments to the senior debt terms. A priority amount is not uncommon over which the senior debt will not rank ahead of the junior debt and which amount may not be amended. The amount may be up to 20% more than the prevailing amount of the senior debt principal together with hedging liabilities, fees, an estimate of enforcement expenses and, of course, interest. Prohibition or restriction on changes to the maximum principal sum of the senior debt and its interest rate are common. Shortening the term for scheduled repayments of senior debt may also be prohibited in the intercreditor agreement. In addition, senior debt holders may be required not to change their borrowing base and may be prevented from using cash or other reserves of the borrower.
Further advances. Sometimes junior creditors try, usually unsuccessfully, to have further advances by the senior debt holder treated as junior debt, but treating these advances as junior debt does not usually make sense if the purpose of the advances is to preserve collateral.