When several organisations lend a company money they will not only agree with the debtor company what the terms of the deal are, but will need to come to arrangements between themselves to establish how their competing interests towards that company will be handled in the event of a dispute.
There are various ways in which the priority of the different levels of debt a company has are regulated. These include statutory provisions, but can also involve specifically agreed contractual arrangements. Different classes of creditor can enter into these arrangements, known as intercreditor agreements, which assign priority to one creditor or another. This guide deals with general points arising from these intercreditor documents.
Lending transactions are rarely as simple as one party borrowing money from another and paying it back, plus interest, over an agreed period of time. Companies borrow money from lots of different sources in lots of different ways for lots of different reasons. In some cases, a company will incur a lot of debt in comparison to its equity base, or true assets. Such a company will often be described as being highly leveraged or highly geared, and lending to these companies is often called 'leveraged finance'.
Leveraged finance is more risky for the lender and so the cost will be higher than for normal borrowing. This type of financing is often used to achieve a specific – and often temporary - objective, such as making an acquisition or funding a buy-out.
There are often different layers and types of agreement involved in leveraged financing. Intercreditor documents are used to give legal effect to what in actual terms is the level of risk present in each different type of arrangement. In simple terms, the ranking of these layers of finance in order of increasing risk is:
- senior debt: the debt that takes priority over other unsecured or more 'junior' loans, and which therefore theoretically must be paid first in the event of insolvency;
- junior debt, including mezzanine or in between' debt: the less secure debts, where investors take on more risk at a greater cost to the borrower;
- equity, including quasi-equity in the form of institutional, management or vendor loan notes: the least secure interest in a company, based on whatever assets are left over after all the other creditors have been paid.
This order of priority may be achieved in three ways:
- the senior and junior debt will be secured;
- share capital will normally rank behind debt in an insolvency situation as a matter of legal principle; and
- contractual arrangements between creditors can be created to deal with the rights of the various parties to receive payment in respect of the finance they have provided, and to deal with how these rights work in relation to other creditors.
Additional contractual arrangements can also be put into place to supplement the effect of giving security, or to stop debt automatically taking priority over share capital. These additional contractual arrangements can be considered on two levels – senior debt vs. junior and mezzanine debt, and senior debt vs. equity.
Senior debt vs. junior debt
An intercreditor agreement between a senior creditor and a junior creditor should contain the following provisions and deal with the following main issues:
Senior debt: The definition of senior debt should include all elements of the senior debt facilities. This can include acquisition term facilities, revolving facilities, working capital/overdraft facilities and ancillary facilities. Hedging arrangements, which allow a company to offset certain specific gains against certain specific losses, also rank alongside senior debt in terms of priority of payment.
There may well be an overall limit on the amount of the senior debt which is to take priority over the junior debt. This will be agreed on a transaction to transaction basis, and should always include sufficient leeway to give the senior creditor some flexibility to provide additional credit to the borrower if necessary.
Junior debt: This definition must be wide enough to cover all amounts, owing from all members of the borrower group of companies, to the junior creditors whether in respect of principal amount or interest. If applicable, the definition should extend to cover any amounts which may become owing in respect of shares which may be issued to the junior creditors.
Borrower group: This should include the principal borrower, but should also include all other members of the group of companies which may incur any junior debt. It should definitely include any group member which has given a guarantee in favour of the junior creditors.
Payment restrictions and other undertakings: These are the undertakings which assign priority to the different debts before an insolvency event occurs. They should be given both by the borrower group, and the relevant junior creditors.
Except for permitted payments, which are dealt with below, the borrower group should agree not to pay or prepay any of the junior debt and the junior creditors should agree not to accept payment of, accelerate or commence proceedings for the recovery of any of the junior debt. These undertakings will apply until all of the senior debt and any hedging liabilities have been repaid in full.
The borrower group and the junior creditors will also agree respectively not to create or accept or enforce any security in respect of the junior debt, except that which is agreed as part of the junior debt security package.
Permitted payments: The first repayment of the principal amount in respect of the junior debt should come after the last repayment of the principal of the senior debt. Therefore, the only payments to the junior debtor which will be allowed during the term of the senior debt will be in relation to interest on the junior debt and the payment of certain fees and expenses. These payments will be subject to certain conditions, including:
- that no event of default, or possible potential event of default, has occurred under the senior financial arrangement;
- a 'look back' or 'look forward' test has been satisfied, to verify that there has been no financial covenant breach within a specified time up to or after the proposed permitted payment date;
- the senior creditor has not accelerated or enforced its senior debt.
If there is any breach of the above conditions then the permitted payment may either be automatically blocked or blocked after a positive act on behalf of the senior creditor, for example, the issue of a stop notice.
Standstill periods: The payment/deferral undertakings covered above prevent the junior creditors from accelerating the junior debt and enforcing the security they hold in respect of this debt even where an event of default has occurred under the relevant junior debt agreement. This should remain the case until the senior creditor has been repaid in full, unless agreed otherwise. Such agreement may be reached in certain circumstances, particularly if the senior creditor has accelerated or enforced its own debt or security. At this point, there is nothing to prevent the junior creditor from accelerating or commencing enforcement proceedings as long as any priority arrangements still apply in favour of the senior creditor.
However, the junior creditors may not wish to have their rights of acceleration and enforcement restricted only to this serious circumstance. It is therefore common for an intercreditor agreement between a senior and junior or mezzanine creditor to contain a 'standstill provision'.
Standstill provisions state that where an event of default has occurred in respect of the junior debt, the junior creditor may serve notice on the senior creditor that it intends to accelerate its debt or take steps to enforce its security after a certain period. There then follows the standstill period, where the junior creditor remains restricted in its ability to accelerate or take enforcement action, after which the restrictions are lifted on the basis that the senior debt still ranks ahead of the junior debt in terms of repayment.
The length of a standstill period is subject to negotiation.
Override provisions: These provide that, where a certain default occurs under the senior debt arrangement and the equivalent default occurs under the junior debt arrangement, if the senior creditor waives this default then there is also deemed a waiver of the default under the junior debt documents. Similarly, certain consents given by the senior creditor will also be deemed given by the junior creditor.
The category of defaults or consents which these override provisions apply to may be limited to administrative and procedural matters. Alternatively, the provisions may be drafted to cover all defaults and covenants subject to a long list of exceptions giving the junior creditor certain rights.
Subordination upon insolvency: This is another key provision, and is intended to postpone the junior creditor's claims to the senior creditor's claims in the event that the borrower group is wound up. The junior creditor's agreement to this postponement is usually in addition to an undertaking from the junior creditor not to go after the junior debt in any insolvency proceedings until the senior debt has been fully discharged. There may also be a provision requiring a liquidator to be given appropriate instructions to effect this postponement. Finally, there will also be a turnover provision so that, to the extent that the junior creditor receives any amount contrary to those subordination provisions, this amount must be turned over to the senior creditor to satisfy any outstanding debt.
Priority of encumbrances: If the junior creditor has the benefit of security for the junior debt, it must remember to include a provision in the security agreement stating that the senior creditor's security ranks in priority.
Amendments to documentation: There will be certain undertakings from both the senior creditor and the junior creditor in respect of amendments to their respective debt documents.
The senior creditor will agree that it can amend its debt documentation, except:
- to increase the margin, change the basis of the calculation of interest or the currency of the senior debt;
- to the extent that the financial covenants or events of default would be materially more of a burden on the borrower;
- to defer the final repayment date; and
- to increase the amount of the senior debt (possible subject to an agreed limit).
The junior creditor will agree that it can not make any amendments, except:
- amendments which have no adverse economic effect on the interests of the senior creditor;
- to correct typographical errors and omissions; and
- amendments which are also made to the senior debt documents, or to which the senior creditor otherwise consents.
Transfer restrictions: The senior creditor must be able to assign or transfer its rights and obligations under the intercreditor agreement to any assignee or transferee of the senior debt - likely to be limited to assignees or transferees permitted under the senior facilities agreement. In the same way, the junior creditor should be able to assign or transfer its rights and obligations under the intercreditor agreement to an assignee or transferee of the junior debt, but only if the relevant assignee or transferee first agrees to the intercreditor agreement as a junior creditor.
Senior debt vs. equity
An intercreditor agreement between a senior creditor and an institutional investor should contain the following provisions and deal with the following main issues:
Prior debt: This or a similar definition should be used to cover both the senior debt and also, if applicable, any junior debt – all of this debt will rank in priority to the institutional investor debt.
Institutional/subordinated debt: This definition must be wide enough to cover all amounts owing from the borrower group to the institutional investor, including in respect of shares.
Deferred consideration is when a vendor defers all or part of the proceeds from the sale of a business and agrees that the purchaser can pay some or all of the cost from cash generated at a later date. Where a funding structure includes vendor deferred consideration/loan notes, then such debt should also be subordinated under similar provisions as those relevant to the senior debt vs. equity relationship. This will often cause more commercial than legal negotiation, and should therefore be raised in the early stages of any transaction.
Borrower group: Again, this should not only include the principal borrower but also any other member of the borrower group which is giving a guarantee or security to the institutional investor and which will therefore have a legal duty to the institutional investor.
Institutional investor/subordinated creditor: This definition should, in theory, extent to any party to which the institutional/subordinated debt is owed. Technically this would include all of the shareholders in the principal borrower, whether or not they were also the holders of quasi-equity in the form of loan notes. However, it has become market practice not to include individual members of the company's management team if they only hold ordinary share capital with no fixed equity yield. If they do hold loan notes or preference shares with a right to a scheduled equity yield, they may well need to be included as parties to the intercreditor agreement.
Prior creditors: As with the definition of prior debt, this should include both the senior creditor and any junior creditor if applicable.
Payment restrictions and other undertakings: These will be the same as those detailed above – the only change will be that the references to 'junior debt' and 'junior creditors' will be replaced by 'institutional/subordinated debt' and 'institutional investors/subordinated creditors'.
Permitted payments: These will normally be limited to scheduled payments of fixed dividends on any preference shares, and interest on the institutional loan notes - referred to as equity yield.
Sometimes, if the borrower group is performing over and above business plan projections, the senior creditor may agree to the institutional investor receiving an additional, participating dividend. This may be on the condition that a certain amount of the senior debt has been or is at the same time to be prepaid early.
It would be very unusual for permitted payments to include principal amounts of loan notes or share capital. The repayment dates for institutional loan notes and the redemption dates for institutional preference shares should begin after the scheduled final date for repayment of any senior debt.
As with the senior debt vs. junior debt intercreditor agreement, the payment of an equity yield will be subject to certain payment conditions. These will usually be stricter than those applying to junior debt permitted payments, and will include the following:
- no event of default, or possibly potential event of default, having occurred under both the senior and junior/mezzanine facilities agreements. There may be more scope in the senior debt vs. equity intercreditor agreement for agreeing that any event or potential event of default should act as a payment restriction.
As regards any test of financial covenant compliance, the senior and junior creditors should always seek to link the payment of the equity yield to the delivery of the financial information necessary to test the financial covenants. The equity yield payment dates should be set to coincide with the delivery of this information for the period at the end of which the financial covenants are due to be tested or preferably a short time after this date. If, as is usual, the financial covenants are tested quarterly and the equity yield is payable half-yearly then the payment dates should be set about 10 days after the due dates for delivery of the quarterly financial information on the two relevant quarter end test dates;
- a 'look back' or 'look forward' test having been satisfied, with a look forward test being more common. The relevant period for the look forward test should be sufficiently long as to include at least the next financial covenant test date - and possibly the next two;
- neither the senior creditor nor the junior creditor has accelerated or enforced its debt.
As with the senior debt vs. junior debt provisions, if there is any breach of the above conditions then the permitted payment may be blocked automatically or may require the issue of a stop notice.
Standstill period: there should be no standstill period in a senior debt vs. equity intercreditor agreement, as the institutional investor should never be permitted to accelerate any of its debt or enforce any security before the senior and junior debt have been repaid in full. The institutional investor should be treated as the equity provider it really is, and should not gain and right of acceleration simply because it has invested by way of a debt instrument.
Permitted encumbrances: it is relatively uncommon for an institutional investor's loan notes to be secured but, if they are, the security should be a permitted encumbrance. In addition, if the loan notes are secured then a provision should be included confirming that the security for the senior and junior debt takes priority over the security for the loan notes.
Override provisions: these provisions in a senior debt vs. equity intercreditor agreement should be wider than in the context of a senior debt vs. junior debt intercreditor agreement. This reflects the lower ranking of the institutional investor compared with the junior creditor. Consequently, the institutional investor should not have any of the rights given to the junior creditor detailed above.
Subordination upon insolvency: these provisions should be the same as are included in a senior debt vs. junior debt intercreditor agreement. The provisions are important to ensure that any institutional investor loan notes will be given less of a priority as share capital will normally be considered subordinate upon insolvency automatically by law.
Amendments to documentation: there should be no undertaking from the senior and junior creditor with respect to amendments to their respective debt documents. However, there should be a wide undertaking by the institutional investor not to amend any of its equity documents (including any loan note instrument).
Transfer restrictions: the senior and junior creditor must be able to assign or transfer their rights and obligations under the intercreditor agreement to any assignee or transferee of the senior or junior debt. As with the senior debt vs. junior debt intercreditor agreement, the same provisions should apply to the institutional investor but only if any transferee or assignee first agrees to the intercreditor agreement as an institutional investor/subordinated creditor.