An Overview Of Silent 2nd-Lien Loans In The US And Europe

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By Frederick Fisher, Thomas Kiriakos, Andrew Crotty and Alex Dell

Law360, New York (May 23, 2017, 3:38 PM EDT) -- Many capital structures include

one or more debt facilities that are junior to senior debt secured by the same

assets or property. One such type of junior debt that doesn’t fit neatly in traditional

structures, but is commonly discussed, is debt with a “silent second lien.” This

article briefly describes the silent second-lien debt product (including how this

terminology is often vaguely used or overused in the market), highlights some

differences between the U.S. and European markets, and discusses considerations

in connection with the use of the product in each market and in cross-border

transactions.

Overview

Lenders choose to extend credit on a secured or unsecured basis based on market

conditions, the borrower’s historical and projected performance and perceived

ability to repay the debt, and an evaluation of other relevant factors. One type of

secured debt is silent second-lien debt, which is usually provided in the form of

loans (as opposed to notes).

There can be a debate in the lending markets as to all of the elements of a “silent

second lien,” and the term “silent second,” although used often in deal

negotiations, has different meanings to different institutions and different

meanings in the United States and Europe. Conceptually, at least in the United

States, the structure generally is used where junior debt would otherwise be

unsecured but is accorded a junior lien on the first-lien lender’s collateral for the

purpose of capturing on a priority basis (including ahead of trade debt) any residual

value of the collateral remaining after satisfaction of the first-lien debt.

In these situations, the junior-lien lender’s rights in and to the collateral are to be

passive or “silent,” and the first-lien lender’s rights in and to the collateral generally

are to be unimpaired and unimpeded. In the underlying intercreditor documents,

this generally is reflected by the junior lender subordinating its lien and severely

limiting its enforcement and other rights in favor of the senior lender in exchange

for receiving a co-extensive lien on all of the collateral held by the senior lender.

Such an arrangement would likely take on many characteristics of mezzanine

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financing, including an expectation of an extended or complete standstill in the event of a borrower

default.

In the U.S. debt markets, the components of the silent second-lien position can include agreement by

the silent second-lien lender to:

 subordinate its lien priority in all respects to the lien securing the obligations of the first-lien

lender, irrespective of the manner or order of grant or perfection or of validity, perfection or

priority, including in bankruptcy, of such lien;

 cooperate so that the lien of the first-lien lender extends to the same collateral as securing its

second lien;

 not object to the validity or enforceability of the first-lien lender’s security interest;

 not take certain enforcement actions with respect to the shared collateral (but instead be

subject to a standstill), in the event of a payment and/or other default by the borrower, in favor

of the first-lien lender taking such actions and not challenge such actions by the first-lien lender;

 generally cooperate in connection with the first-lien lender’s exercise of remedies, including

being required to release its liens in certain circumstances;

 not receive or retain (but instead be affirmatively obligated to turn over to the first-lien lender)

any proceeds of dispositions of the collateral until payment in full of the first-lien lender’s

claims, even if the first lien is avoided in bankruptcy or otherwise nullified or if the first-lien

lender’s claims are disallowed (e.g., post-bankruptcy interest owing to an undersecured

creditor);

 waive certain rights usually associated with status as a lender with secured and/or unsecured

claims;

 limit its rights to vote on the borrower’s plan of reorganization in bankruptcy (e.g., that the

second-lien lender will vote in alignment with the first-lien lender or at least not vote for a plan

that is inconsistent with the other provisions of the operative subordination agreement);

 not oppose the first-lien lender’s other decisions in bankruptcy, e.g., to permit the use of cash

collateral and to provide (or permit) post-petition financing on a “superpriority” basis regarding

adequate protection or regarding dispositions in respect of shared collateral; and

 permit the refinancing of the first-lien lender’s debt, with the replacement facility to succeed to

the benefits of such “silent second” arrangement.

In European-only transactions, the term “silent” is rarely used although the main principles of “silent”

second liens are present and accepted when structuring European transactions.

A table summarizing and comparing certain aspects of the silent second-lien product in the U.S. and

European practices is provided below. One of the more interesting takeaways from this analysis is that

even if the underlying result is similar, the rationale and approach is different. For instance: (1) in

Europe, junior secured debt may often appear “silent” in the U.S. sense in order to account for legal or

corporate benefit restrictions in certain jurisdictions that restrict financial assistance or prohibit

subsidiary guarantors of the borrower’s debt from providing full cross-collateralized and cross-

guaranteed support (rather than for the financial and business motives in the United States); (2) in U.S.

practice, it is assumed that in the event of the borrower’s bankruptcy, the borrower will be reorganized

or its assets liquidated under the U.S. Bankruptcy Code, whereas in European practice, no such

assumption is made as no consistent equivalent court-approved process readily exists across European

insolvency regimes, and therefore, the focus on intercreditor arrangements is to facilitate a swift

enforcement sale outside of court and bankruptcy proceedings and the effective distribution, among

creditors, of sale proceeds or recoveries.

Feature

U.S. Practice

European Practice

Documentation

First-lien and second-lien debt

often documented in separate

and independent debt

instruments, including security

documents, and subject to an

intercreditor agreement.

First-lien and second-lien debt

generally documented in

separate and independent debt

instruments. There will

generally be only one set of

security documents, which are

held by a common security

agent on behalf of the first- and

second-lien creditors with the

first-lien/second-lien structure

being contractually agreed to in

an intercreditor agreement

signed by all creditors.

Subordination

Generally, complete lien

subordination, but level of debt

subordination varies, from no

debt (only lien) subordination up

to and including complete

payment subordination until the

first-lien debt is paid in full.

Usually contractually

subordinated to first-lien debt in

relation to both secured and

unsecured recoveries.

Scope of Security

Same as first-lien/senior debt.

Same as United States.

Ranking of Security

Ranking second to first-

lien/senior debt.

Same as United States. Because

there is generally a shared

security package documented in

one set of security documents,

the second-lien lenders will

contractually agree in the

intercreditor agreement that

the first-lien debt ranks ahead of

the second-lien debt in relation

to such security.

Feature

U.S. Practice

European Practice

Payment Block in the Event

of a Payment Default on

First-Lien Debt by Borrower

Usually (a) permanent until first-

lien debt is paid in full, (b) for a

time period such as 90-180 days

or (c) none, with (b) being the

most common for institutional

nonaffiliated parties. This has the

potential to be highly negotiated.

Same as United States but more

likely to have a set period of

time.

Payment Block for Other

Defaults by Borrower

Usually (a) for a time period such

as 90-180 days or (b) none, with

(a) being the most common for

institutional nonaffiliated parties.

This has the potential to be highly

negotiated.

Same as United States, but more

likely to have a set period of

time.

Unsecured Creditor Rights of

Second-Lien Lender

Usually extremely limited, subject

to material failure by the first-lien

lender to take enforcement

action and/or standstill time

period (e.g., 90-180 days).

Same as United States, but

standstill periods are often

shorter (e.g., 75-90 days).

Secured Creditor

Enforcement Rights of

Second-Lien Lender

Same as above. In short, the first-

lien lender is expected to be able

to "drive the bus" when it comes

to the enforcement of remedies.

Same as above, but the first-lien

lenders retain control of the

enforcement process unless

they instruct the security agent

not to enforce or do not provide

instructions to the security

agent within a certain period of

time. Enforcement includes

making payment claims under

any guarantees.

Bankruptcy

Fundamental elements of

arrangement, e.g., subordination

and accompanying turnover

obligations expressly continue

into and apply in bankruptcy.

Also, there will be bankruptcy-

specific provisions — including as

to plan voting, use of cash

collateral, post-petition financing

on a "super-priority" basis, and

bankruptcy sales — expressly

setting forth the dominant rights

of the first-lien lender. The range

with respect to the negotiation of

For the reasons discussed in the

text above, usually not as

detailed or specific as in the

United States.

Feature

U.S. Practice

European Practice

these bankruptcy-specific

provisions varies depending on

the provision at issue and the

other particular circumstances of

the transaction. For example, it is

not uncommon to see the ability

of the first-lien lender to provide

(or consent to) post-petition

financing on a "superpriority"

basis limited to a negotiated

maximum amount or "basket" of

"superpriority" debt.

First-Lien Purchase Option

upon

Acceleration/Enforcement of

First Lien

Depends on relative sizes of the

first-lien and second-lien facilities,

but overall generally available in

full (at par) on a "nonrecourse"

basis and with a release of liability

by the second-lien purchaser in

favor of the first-lien lender. Also,

there often is negotiation over

related terms, such as notice

rights, length of exercise period,

and standstill (or no standstill) by

the first-lien lender during the

exercise period.

Same as United States.

Considerations

Silent second-lien loans are important in the marketplace because they allow for a borrower to access

additional capital when it might not otherwise be available. Silent second-lien loans may also provide

advantageous pricing or other terms compared to traditional mezzanine or unsecured debt or

incentivize a lender to continue in a credit or expand their loan at a time when they would otherwise not

be able to do so on an unsecured basis.

There are also benefits to lenders in deploying silent second-lien debt in a borrower’s capital structure.

First-lien lenders benefit because silent second-lien debt decreases the amount of financing that the

first-lien lender is asked to provide to the borrower and may enable refinancings and other transactions

that might not otherwise be possible. Silent second-lien lenders benefit from placing themselves ahead

of the unsecured creditors in a liquidation or reorganization.

Potential drawbacks to a silent second-lien position chiefly include disagreement in the documentation

stage over the scope of the meaning of “silent,” even after agreement in concept at the term sheet or

negotiation stage. “Silent” often means different things to different parties, and disagreement on

meaning can lead to a significant roadblock during negotiations. Specific areas of contention may

include triggering events and the time periods for payment blockages, ability to provide post-bankruptcy

financing on a “superpriority” basis, ability to sell assets without the consent of the second-lien holder,

and circumstances for enforcement of rights and remedies.

One example: a silent second-lien lender interprets its retained unsecured creditor rights to include the

ability to take certain actions to frustrate the first-lien lender’s efforts to exercise rights against shared

collateral, while the first-lien lender interprets “silent” to mean that the silent second-lien lender must

waive all of its rights to object to the first-lien lender’s actions.

In cross-border deals, further confusion can result from a failure to recognize that the various market

standards on how to document second-lien positions, including silent second liens, may not translate as

expected to U.S. market practice.

Recent Trends

In our practices in 2016 and during the first part of 2017, we recognized a divergence in the use of silent

second-lien debt between the U.S. and European finance markets. In the United States, we saw the use

of silent second-lien debt increase, primarily due to (1) leveraged lending regulations constraining the

availability of first-lien secured debt from “traditional” regulated lenders, (2) increased participation of

nontraditional lenders and investors and (3) advantageous pricing as compared with mezzanine or

unsecured debt. In Europe, we saw the use of silent second-lien debt decrease for a variety of reasons,

including increased liquidity, which meant that desired leverage levels could be achieved with senior or

unitranche debt.

Additionally, the circumstances under which silent second-lien debt is employed in a transaction have

differed between the U.S. and European markets in recent years. In the United States, we have noted an

increased use of silent second-lien loans by borrowers that are in the middle market and/or lower-

performing or distressed situations. By contrast, in Europe, we have noted an increased use of second-

lien loans (including silent second-lien loans) due to increasing competition between banks and

alternative lenders, which has involved an increased offering of financing products and the need to

invest in higher-yielding structures to compensate declining margins.

Conclusion

Silent second-lien debt can provide an attractive financing option to borrowers and lenders alike,

allowing certain borrowers to bridge a capital gap and consummate a transaction or take advantage of

opportunities that might not otherwise be available. So long as leveraged lending guidelines and other

regulations restrict the availability of capital from traditional, regulated banking entities and there is a

demand for the silent second-lien product offered at an attractive rate to borrowers and lenders, the

product will continue to be available and evolve to meet those demands. Capital structures including

silent second-lien debt can be complicated, particularly in cross-border transactions involving, for

example, different insolvency or contract laws. Fortunately, potential drawbacks and risks associated

with lending on a silent second-lien basis can be mitigated with some advance planning and detailed

discussion on deal terms and coordination among various jurisdictions, particularly in each instance at

the term sheet stage, to avoid any misunderstanding on what “silent” means in a given transaction.

Frederick C. Fisher and Thomas S. Kiriakos are partners in the Chicago office of Mayer Brown LLP. Andrew

Crotty and Alex Dell are partners in the firm's London office.

Mayer Brown attorneys Martin Philipp Heuber, François-Régis Gonon and Anastasia N. Kaup also

contributed to this article.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its

clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general

information purposes and is not intended to be and should not be taken as legal advice.