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The ION Media Decision: Second Lien Lenders Treated as Second Class Citizens, Even as to Unencumbered Assets

November 30, 2009

In the chapter 11 proceedings for ION Media Networks, a distressed fund (Cyrus) purchased second lien debt and then employed what the Court characterized as "aggressive bankruptcy litigation tactics as a means to gain negotiating leverage." In a November 24, 2009 Memorandum Decision, Judge James Peck of the United States Bankruptcy Court for the Southern District of New York stopped Cyrus in its tracks, holding that the Intercreditor Agreement (ICA) between the first lien and second lien lenders would be enforced to deny Cyrus (i) the ability to assert that certain assets were outside of the collateral package and (ii) standing to object to the proposed plan of reorganization, even in its capacity as an unsecured creditor due to its substantial deficiency claims. A copy of the ION Media decision can be found here.

The ION decision is a strong "shot across the bow" of second lien lenders, in at least three respects:

  • First, the ION decision rigorously enforced the ICA against Cyrus not only as to proceeds of "Collateral," which is to be expected, but also as to proceeds of assets that were never part of the collateral package at all. This could signal a major judicial departure from the general commercial understanding that intercreditor agreements govern relative rights as to collateral - so-called "lien subordination" - by suggesting that intercreditor agreements should also be interpreted as providing for so-called "debt subordination" even as to certain unencumbered assets.
  • Second, while Bankruptcy Code section 510(a) clearly permits bankruptcy courts to enforce the subordination provisions of an intercreditor agreement, ION Media went a step further in enforcing some of the non-subordination provisions of the ICA, including the second lien lenders' waiver of the right to contest a plan of reorganization supported by the first lien lenders.
  • Third, the Court took exception to Cyrus' conduct in seeking to enforce its rights. However, even if one accepts the Court's view that Cyrus was overly aggressive under the circumstances, the Court adds troubling judicial gloss as to the motivations of investors who purchase debt "for pennies on the dollar." Even though the Court asserted that it saw "nothing wrong with raising and pursuing opportunistic legal theories," the Court's language in the very first paragraph of the decision, and repeatedly thereafter, suggests a harsher view.

Denial of Standing as to Unencumbered Assets

The most troubling aspect of the ION decision is the Court's denial of standing to Cyrus as a party in interest with respect to FCC licenses that were owned by special purpose vehicles within the debtors' capital structure and were unencumbered (not mistakenly, but as a matter of law and as an acknowledged term of the original deal). As unencumbered assets, their value should presumably have been available to satisfy unsecured claims on a pari passu basis, including Cyrus' substantial deficiency claim. The ION Media ICA appeared to support this conclusion by including a common provision that preserved the unsecured rights of the second lien lenders. In other words, while the ICA subordinated the liens of the second lien lenders, it did not subordinate their debt claims.  Notwithstanding this, the Court concluded that the ICA precluded Cyrus from even making the argument that it was entitled to pari passu treatment with respect to the value of the FCC licenses.

Specifically, the court looked to the following language in the ICA:

Each of the Secured Parties acknowledges and agrees (x) to the relative priorities as to the Collateral (and the application of proceeds therefrom) as provided in the Security Agreement…and acknowledges and agrees that such priorities (and the application of proceeds from the Collateral) shall not be affected or impaired in any manner whatsoever including, without limitation, on account of…any non perfection of any lien purportedly securing any of the Secured Obligations (including, without limitation, whether any such Lien is now perfected, hereafter ceases to be perfected, is avoidable by any bankruptcy trustee or otherwise is set aside, invalidated, or lapses).

Seizing on the use of the term "purportedly securing," the Court determined that "the language of the Intercreditor Agreement demonstrates that the Second Lien Lenders agreed to be 'silent' as to any dispute regarding the validity of liens granted by the Debtors in favor of the First Lien Lenders and conclusively accepted their relative priorities regardless of whether a lien was ever properly granted in the FCC Licenses."

The Court further found that even if Cyrus had standing to contest the priority of the first lien lenders' claims, Cyrus would not prevail. Citing the lien subordination language in the ICA, the Court concluded that "purported" collateral is "a proper subject of the agreement to the same extent as any asset that fits the definition of Collateral." In other words, as long as first lien lenders assert that certain assets should be treated as "Collateral," second lien lenders are prohibited even from making the argument that those assets were never intended to be "Collateral" to begin with.

The Court also justified its conclusions based on the public policy that "[a]ffirming the legal efficacy of unambiguous intercreditor agreements leads to more predictable and efficient commercial outcomes and minimizes the potential for wasteful and vexatious litigation." The Court found that "the parties contemporaneously recognized and disclosed the uncertainty surrounding the ability to grant a direct security interest in an FCC license" while simultaneously "manifest[ing] their intent to insulate the First Lien Lenders' collateral package from attack by the Second Lien Lenders and to thereby ensure that any economic value associated with the FCC Licenses was included in the First Lien Lenders' collateral package."

Finally, the Court found that the DIP financing order, which provided that the first lien debt is secured by "first priority liens on and security interest in substantially all of the Debtors' assets," prohibited Cyrus from subsequently challenging the validity of the first lien lenders' liens on the FCC licenses.

It is interesting to note that the Court did not address the important distinction between lien attachment and lien perfection. A lien "attaches" when an obligor grants a creditor a lien, for value, in property that the obligor has rights in. However, the lien is generally not enforceable against third parties unless the lien is properly "perfected" under applicable law. It is correct to say that a typical intercreditor agreement provides for subordination once a lien has attached, even if the lien is never perfected (or is subsequently avoided). In ION Media, however, the lien never attached, for the simple reason that FCC licenses cannot be the subject of a lien as a matter of law. Nevertheless, the Court's reasoning appears to be that the first and second lien lenders somehow intended and public policy apparently required that the FCC licenses be treated as Collateral even though, in fact, no lien ever attached - a rather harsh result for the second lien lenders whose rights as unsecured creditors were expressly preserved in the ICA.

Denial of Standing to Object to Plan of Reorganization

The Court further found that Cyrus lacked the standing to file an objection to the Plan. Calling the language "plain and purposeful," the Court held that it had the authority to enforce the provision in the ICA stating that the second lien lenders could not "oppose, object to or vote against any plan of reorganization or disclosure statement the terms of which are consistent with the rights of the First Priority Secured Parties under the Security Agreement." 

In so doing, the Court rejected Cyrus' argument that it had standing to object to the plan in its capacity as a general unsecured creditor. Specifically, the court noted that the language of the Intercreditor Agreement only allowed the secured parties to exercise rights and remedies as unsecured creditors to the extent they are not otherwise specifically prohibited. As the second lien lenders were directly prohibited from objecting to the plan as secured creditors, the Court found that Cyrus could not object to the plan as an unsecured creditor, even though the FCC licenses were knowingly unencumbered under the documents and Cyrus' objection was based, in part, of the fact that the value of the FCC licenses were not being shared with unsecured creditors.

Moreover, the Court found that "Cyrus has been willful in its treatment of the Intercreditor Agreement as inapplicable to it simply on the basis of its own untested theory as to what does and does not fall within the definition of Collateral." The Court went on to state that "[a]pparently without regard for the consequences of its actions, Cyrus has chosen to treat the Intercreditor Agreement as inapplicable to its conduct in these cases resulting in a material increase in the overall cost of administration in these cases. This added expense is unjustified."

Lessons Learned

Sometimes bad facts make for difficult decisions, and the ION Court certainly took strong exception to Cyrus' strategy and tactics throughout the case. Nevertheless, the ION decision appears to state general propositions concerning intercreditor agreements that are inconsistent with general market expectations.

First, the market assumes that any assets that do not come within the definition of "Collateral" should be treated as excluded from treatment as Collateral for all purposes, including lien subordination. The ION Media decision suggests that future intercreditor agreements should state this more explicitly, including, if possible, identifying specific excluded asset classes (such as FCC licenses).

Second, the market assumes that, while the lien subordination provisions of intercreditor agreements are subject to bankruptcy court enforcement, the non-subordination provisions should be treated as a matter of private contract between the first and second lien lenders, particularly when (as here) the debtor is not even a party to the agreement. This would suggest that future intercreditor agreements should be clearer on this point, but the truth is that intercreditor agreements for new financings are negotiated by the first lien agent, so any "clarification" in the future would likely be adverse to second lien interests.

Third, second lien lenders need to be careful in "choosing their battles," meaning that staging a public fight at every step of the proceedings could damage the second lien lenders' credibility on the issues that really do matter. This is particularly true in the context of a plan of reorganization that, as in ION Media, has the support of virtually all other constituents. In truth, intercreditor agreements are relatively restrictive as to the rights of second lien lenders, and there is always the risk that a court will side with the first lien lenders and the debtor when it is a "close call."

Finally, ION Media is a single decision and it is fact-dependent.  CCS Medical is a good example of a second lien case reaching different conclusions based in part on different facts. In CCS Medical, the Delaware bankruptcy court recently sided with the second lien lenders (represented by Bracewell & Giuliani) in denying confirmation of a plan supported by the first lien lenders as well as the debtor. The court further concluded that an official second lien lender committee was appropriate under the unusual circumstances involved. Bracewell will be putting out a more detailed update on CCS Medical shortly.