Intercreditor agreement: Meaning, Criticisms & Real-World Uses

What Is an Intercreditor Agreement?

An intercreditor agreement is a legally binding contract between two or more creditors who have made loans to the same borrower. This agreement, a key component within secured transactions, defines the relative rights, priorities, and obligations of each lender regarding the borrower's collateral and the repayment of their respective debt. Its primary purpose is to establish clear rules, particularly in scenarios of default or bankruptcy, to prevent disputes among lenders and ensure an orderly process for the distribution of proceeds from the borrower's assets²⁰.

History and Origin

The evolution of the intercreditor agreement is closely tied to the increasing complexity of corporate financing structures. As companies began to seek funding from multiple sources, offering various types of secured loans and unsecured debt, the need for a framework to manage potential conflicts among lenders became apparent. Historically, lenders might have relied on general contract law principles or the Uniform Commercial Code (UCC) to determine priority, often favoring the "first to file or perfect" rule for security interests¹⁹.

However, the UCC also recognizes that parties can alter these default rules by contract. Thus, the intercreditor agreement emerged as a crucial tool to expressly override statutory priorities and establish a contractual order of repayment and enforcement rights tailored to specific financing arrangements¹⁸. This became particularly important with the rise of leveraged finance transactions involving multiple layers of debt, such as senior debt and subordinated debt, in the same capital structure. The agreement has adapted over time to accommodate developments in the loan market, including the ability for borrowers to incur incremental debt and for multiple credit facilities to exist at various priority levels¹⁷.

Key Takeaways

An intercreditor agreement is a contract between multiple lenders to the same borrower, clarifying their rights and priorities regarding collateral and repayment.
It is crucial in complex financing arrangements involving different types or tiers of debt.
The agreement typically outlines the order of repayment, how proceeds from asset sales are distributed, and the actions each lender can take in a default scenario.
Intercreditor agreements help mitigate potential conflicts among creditors, ensuring a more predictable and efficient process during financial distress.
They often define key aspects such as lien priority, standstill periods, and rights in a bankruptcy proceeding.

Interpreting the Intercreditor Agreement

Interpreting an intercreditor agreement involves understanding the precise terms and conditions that govern the relationship between lenders and their claims on the borrower's assets. These agreements are highly customized documents, and their interpretation is paramount for all parties involved, especially when a borrower faces financial difficulties. Key aspects of interpretation include the defined hierarchy of payment priority among different classes of lenders, such as senior versus junior creditors. The agreement will clearly stipulate which lenders get repaid first from the proceeds of collateral in an enforcement or liquidation scenario¹⁶.

Furthermore, an intercreditor agreement details the circumstances under which each lender can exercise their remedies, including limitations like "standstill periods" where junior lenders agree not to take action for a specified duration after a default ¹⁵. It also clarifies rights relating to the control and disposition of collateral, potentially appointing a collateral agent to act on behalf of all secured parties. The enforceability of these agreements, particularly in a bankruptcy context, relies heavily on the clarity and unambiguous nature of their provisions, as courts generally uphold bargained-for rights among creditors¹⁴,¹³.

Hypothetical Example

Consider "Alpha Manufacturing Inc." which needs to finance an expansion. They secure a $50 million senior secured loan from Bank A and a $20 million junior secured loan from Investment Fund B. Both loans are secured by Alpha Manufacturing's inventory and equipment.

To manage the relationship between Bank A and Investment Fund B, an intercreditor agreement is drafted. This agreement stipulates:

Lien Priority: Bank A has a first-priority lien on all of Alpha Manufacturing's inventory and equipment, while Investment Fund B has a second-priority lien on the same assets.
Payment Waterfall: In the event of a liquidation of collateral, proceeds will first go to satisfy Bank A's loan in full (including principal and interest), and only then will any remaining proceeds be used to satisfy Investment Fund B's loan.
Standstill Period: If Alpha Manufacturing defaults on its loan to Bank A, Investment Fund B agrees to a 90-day standstill period, during which it will not initiate any enforcement actions against Alpha Manufacturing or its collateral. This gives Bank A time to assess its options and potentially restructure the loan.
Bankruptcy Rights: The agreement also specifies that in a bankruptcy proceeding, Investment Fund B will not object to Bank A's use of cash collateral or to a debtor-in-possession financing arranged by Bank A.

If Alpha Manufacturing defaults on both loans, Bank A, as the senior lender, would take the lead in enforcing the security interests against the collateral. After liquidating the inventory and equipment, say for $60 million, Bank A would receive its full $50 million. The remaining $10 million would then go to Investment Fund B, leaving $10 million of their $20 million loan unsatisfied, as per the terms of the intercreditor agreement.

Practical Applications

Intercreditor agreements are fundamental documents across various financial sectors, primarily to manage complex debt structures and mitigate inter-lender conflicts. They are most commonly seen in:

Leveraged Finance and Private Equity Deals: In large corporate acquisitions or leveraged buyouts, borrowers often raise capital from multiple lenders, including banks providing revolving credit facilities, institutional investors holding term loans, and private equity funds offering mezzanine financing. Intercreditor agreements clarify the ranking and enforcement rights among these diverse groups of creditors¹².
Real Estate Financing: When a property is financed with both a senior mortgage loan and a subordinate mezzanine loan, an intercreditor agreement is critical. It defines cure rights for the mezzanine lender and consent rights regarding amendments to the senior loan documents¹¹.
Structured Finance: In securitization and other structured products, where different tranches of debt are created and backed by the same pool of assets, intercreditor agreements dictate how cash flows and proceeds are distributed to bondholders with varying seniority.
Distressed Debt and Restructuring: During a company's financial distress or bankruptcy, the intercreditor agreement becomes paramount. It governs how different creditor groups can participate in a restructuring, object to proposed plans, or enforce their claims, as seen in various corporate filings. For instance, SEC filings frequently include intercreditor agreements as exhibits, detailing the relationships between various lenders in a company's capital structure ¹⁰.

These agreements ensure that, even with multiple lenders, there is a clear roadmap for managing the borrower's obligations and assets, especially in challenging economic conditions.

Limitations and Criticisms

While intercreditor agreements are designed to bring clarity and order to multi-lender scenarios, they are not without limitations or criticisms. One significant concern is that they can grant disproportionate influence to senior lenders over the bankruptcy process, potentially at the expense of junior creditors or other investors not directly party to the agreement⁹. Senior creditors, through the terms of an intercreditor agreement, might control the bankruptcy rights of subordinated claims without fully owning those claims, leading to decisions that maximize senior recovery while potentially destroying value for other stakeholders⁸.

For instance, an intercreditor agreement might include "silent second lien" provisions, which restrict the ability of subordinated creditors to participate actively in bankruptcy proceedings, such as contesting liens, objecting to cash collateral motions, or even voting on a plan of reorganization⁷,⁶. This can lead to a situation where junior lenders, despite having valuable information, are silenced, potentially benefiting senior lenders at the expense of other creditors⁵.

The enforceability of certain provisions within intercreditor agreements, particularly those that seek to alter statutory rights in bankruptcy, has also been subject to judicial scrutiny. Courts often require clear and unambiguous language in the agreement to enforce such alterations, and in some cases, have limited subordination agreements strictly to payment priority rather than waiving other statutory rights⁴,³. Furthermore, negotiating these complex documents can be challenging due to differing interests and bargaining power among lenders, and changes in the borrower's financial condition or original loan terms may require amendments that are difficult to achieve²,¹.

Intercreditor Agreement vs. Subordination Agreement

While closely related and often featuring similar provisions, an intercreditor agreement and a subordination agreement serve distinct purposes in complex financing.

A subordination agreement is a more narrowly focused contract, typically between two creditors (or a creditor and a borrower), where one party agrees that its debt or lien will be junior to another party's debt or lien. It primarily establishes the order of payment priority—who gets paid first in the event of a default or liquidation. For example, a homeowner might sign a subordination agreement to allow a new second mortgage to take priority over an existing home equity line of credit.

An intercreditor agreement, on the other hand, is a broader and more comprehensive document. While it almost always includes subordination provisions, it goes beyond just defining payment priority. An intercreditor agreement manages the entire relationship between multiple creditors with claims against the same borrower and its collateral. It addresses a wider range of issues, including:

Enforcement Rights: Which lender has the right to enforce remedies against the borrower and its collateral, and under what conditions (e.g., standstill periods)?
Information Sharing: How information about the borrower's financial condition is shared among lenders.
Amendment Rights: Consent requirements for modifying loan agreements or security documents.
Bankruptcy Protocols: How different lenders will interact in a bankruptcy proceeding, including voting rights and the treatment of collateral.

In essence, a subordination agreement is a component that might be found within a broader intercreditor agreement. The intercreditor agreement provides a complete framework for managing multi-lender relationships, whereas a subordination agreement focuses specifically on the ranking of claims.

FAQs

Q: Why is an intercreditor agreement important?

A: An intercreditor agreement is crucial because it proactively defines the rights and obligations of multiple lenders involved with the same borrower. This clarity helps prevent disputes, reduces legal complexities, and establishes a predictable framework for how loans will be repaid and how collateral will be handled, especially during times of financial distress or default.

Q: Who are the typical parties to an intercreditor agreement?

A: The typical parties include the various creditors (e.g., banks, institutional investors, private equity funds) who have provided financing to a common borrower. It may also involve a collateral agent or administrative agent acting on behalf of a group of lenders.

Q: Can an intercreditor agreement be amended?

A: Yes, an intercreditor agreement can be amended. However, amending it typically requires the consent of the parties involved, often including specified majorities or all of the affected lenders. Changes in a borrower's financial condition or new financing arrangements might necessitate such amendments, which can sometimes be complex to negotiate.

Q: What happens if there's no intercreditor agreement?

A: Without an intercreditor agreement, the rights and priorities of multiple lenders would generally be determined by statutory law, such as the Uniform Commercial Code (UCC) for security interests, or by the specific terms of individual loan agreements. This can lead to ambiguity, increased litigation, and potential conflicts among creditors, especially in a bankruptcy scenario, making the recovery process more contentious and less efficient.