The full scope of the economic fallout from the Covid-19 pandemic has yet to unfold, but it is clear that many businesses are already experiencing and are likely to continue to experience significant financial difficulties because of Covid-19, which may result in a wave of borrower defaults on commercial bank loans.
Where lenders have provided a senior credit facility to a borrower involving a subordinated debt piece, it is essential that the senior lender carefully review the terms of any subordination or an intercreditor agreement between the senior and subordinated lender. Review of such documents should not be an after-thought or a minor detail but rather an important element of the necessary comprehensive analysis of the borrower’s loan documents. Subordination agreements may require that important notices be sent or conditions precedent be met before the senior lender can exercise remedies or amend the senior loan documents. In this brief note, we will review some key components of typical subordination agreements.
Subordination and intercreditor agreements can take many forms depending on the type of transaction involved. For transactions in which both the senior and the subordinated lender have liens on the same collateral, payment blockage and standstill rights are two key components. In these situations, the subordinated lender typically subordinates its rights to exercise remedies against the borrower to the senior lender’s superior rights, with exceptions permitting current payments in the absence of a default. The subordinated lender typically not only subordinates the priority of its lien in the common collateral to the senior lender’s lien, but also agrees to defer or delay taking any action against that collateral for a set period of time, thereby providing the senior lender with an opportunity to control the pace and terms of the exercise of its remedies or to reach a workout arrangement with the borrower.
A payment blockage period is a period of time during which the subordinated lender agrees that it cannot accept or retain payments from the borrower in respect of the subordinated debt. The length and triggers for the commencement of a payment blockage period are usually listed in the subordination agreement. A payment blockage period may be triggered automatically upon the occurrence of certain credit events with respect to the borrower, or the agreement may require that the senior lender send a notice to the subordinated lender and/or the borrower in order to trigger the blockage period. Once the payment blockage period is triggered, however, the borrower and the subordinated lender are prohibited from making and/or receiving payments on the subordinated debt until the blockage period ends. The length of the payment blockage period may vary depending upon how the blockage period was triggered; it could last indefinitely until the senior lender is paid in full or expire a certain number of days after the triggering event.
Another important provision found in subordination agreements is a standstill provision. A standstill is an agreement by the subordinated lender not to exercise remedies against the borrower or the collateral securing the subordinated loan without the prior consent of the senior lender or until the standstill period ends. The standstill period typically commences when the subordinated lender notifies the senior lender in writing of a default on the subordinated obligation and its intent to exercise remedies, and lasts for a specified period of time thereafter, anywhere from at least 180 days to an indefinite period of time until the senior lender has been paid in full.
Payment blockage periods and standstill provisions give the senior lender and the borrower a period of time to negotiate and work out the senior loan. If a workout is not possible, these provisions permit the senior lender to plan out its exercise of rights and remedies and control liquidation of its collateral in the manner it deems best to achieve its goal of repayment, without the pressure of another creditor rushing to exercise its rights and remedies over the same collateral. Without a standstill agreement, senior lenders may be forced to accelerate the senior debt and/or exercise remedies without having the space and time to try to fashion a coherent strategy to address the situation.
Senior lenders that are forced to address problem loans with borrowers and other subordinated creditors should review and understand the scope of any blockage periods or standstill provisions in their subordination agreements early on in the workout process. Should a senior lender take action without reviewing any existing subordination or intercreditor agreement, the lender risks either breaching the agreement and potentially creating additional issues with the borrower and/or the subordinated creditor or failing to take into account the conditions precedent required by the document in order to protect and preserve the senior lender’s rights and priority.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
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