Lcdo. José Gierbolini Bonilla*

I. Introduction

In recent years, and with marked acceleration starting around 2003 and deceleration as the overall debt market remains in crisis, subordinated-lien financings have become an increasingly prevalent alternative to other forms of junior financing, such as unsecured subordinated “mezzanine” debt, and to “high yield” debt. Subordinated-lien financing offered borrowers an additional source of capital that generally had lower interest rates, and therefore substantially reduced cash outflows for debt service, than with the payment subordinated and unsecured alternatives. First lien creditors obtained the usual benefits from a junior financing, including maintenance of a senior position at the top of the borrower’s capital structure and a defined position of control over the exercise of remedies against collateral and to a great degree over the restructuring and bankruptcy process. The subordinated-lien creditors benefited from capturing the residual equity value in the collateral, which would otherwise have to be shared among all senior unsecured creditors of the borrower and achieved many of the advantages available to secured lenders, but not to unsecured lenders, in the event of the borrower’s bankruptcy.

The overheated debt markets from 2003 to 2007 resulted in a record volume of buyout transactions by financial sponsors. The proliferation of subordinated-lien debt provided by hedge funds, private equity funds and other nontraditional investment vehicles like collateralized loan obligations satisfied the demand for leveraged debt created by these acquisitions. In contrast to traditional mezzanine indebtedness, subordinated-lien debt was less expensive and did not dilute the sponsor’s equity ownership. In the current post-credit freeze era, subordinated-lien financing is disappearing, and mezzanine and other subordinated debt options are reemerging to fill the gap between senior loans and equity with a wide range of intercreditor and subordination terms.

As the credit freeze begins to show signs of thawing, private equity groups and strategic acquirers looking to close buyout loans should expect banks and other lenders to approach these transactions with a “back to basics” mentality. Another area in which senior lenders’ renewed preoccupation with fundamentals has manifested itself is intercreditor agreements. By entering into an intercreditor agreement with appropriate standstill, payment blockage, turnover and other key provisions, senior lenders and private equity groups may be able to avoid an unwelcome surprise in the form of a junior lender with the ability to disrupt workout negotiations at a later date.

The expansion in subordinated-lien financings in recent years increases the likelihood that issues will arise in intercreditor agreements with increasing frequency and that those issues will require resolution in the courts. To date, only a handful of reported decisions address Intercreditor Issues provisions and existing case law does not provide a definitive set of rules. This article gives us the opportunity to study lien priorities and the effect of subordination agreements. Ordinarily real property liens have priority according to chronology; the oldest recorded lien is the highest in priority. This scheme can sometimes be altered by a subordination agreement, where a lender with an older, more senior lien, agrees to allow its lien to be junior to a more recently recorded lien. This is often done, for example, when a seller subordinates his purchase money lien to the lien of a construction lender, who will not loan unless it is assured of being in first position.

This article discusses, in general terms, the types of subordination, some of the more common provisions contained in intercreditor agreements, and the Intercreditor Issues that become implicated in subordinated lien financing arrangements, including some of the issues that have been addressed in the courts. Also, this article developed an answer to the question: How does a court decide Lien Priorities when more than one creditor has a security interest issue in the same collateral?

“One who takes so perilous a form of security as a subordinated lien must ever be on the alert, lest by his want of diligence he may suffer the loss of his debt thereby secured.”[1]

II. Subordination

Subordination is most often achieved contractually. The central feature of any contractual subordination arrangement is that the first-lien lender should ensure that its rights and remedies are as free as possible from interference from the second-lien lender. The essential purpose of intercreditor or subordination agreements is for one or more creditors to provide certain protections for the benefit of another creditor or group of creditors in the event of a default by or the bankruptcy of the common debtor. Subordination arrangements can be analogized to limited guaranty arrangements since the essence of an intercreditor agreement is a guaranty or indemnification by the junior creditor for the benefit of the senior creditor of amounts payable or received in bankruptcy or otherwise in contravention of the agreement. The senior, first-lien lender should also control the shared collateral and the actions of the subordinated, junior-lien lender with respect to the common debtor (and often any guarantor) and the collateral. The junior creditor, by contrast, seeks to limit the control and actions of the senior creditor in order to ensure that its junior position has value in the event of a default or bankruptcy by the debtor. In appropriate circumstances, a transaction can be structured to achieve subordination.[2]

A. Debt Subordination

Debt subordination refers to the agreement by a subordinated lender to defer payment of some or all of its claims until the senior loans are paid in full. Partial debt subordination would usually permit a subordinated lender to receive some or all of its scheduled payments in the absence of an event of default under the senior credit facility. Complete debt subordination means that the subordinated lender would not receive any payment on its loans until the senior lender received payment in full on its senior loans. Senior lender might require this type of subordination in a buyout transaction in which a portion of the purchase price is in the form of a note payable to the sellers in order to reduce the amount of cash necessary at closing to complete the acquisition. Second lien loans generally contained limited debt subordination provisions that were only triggered by collection actions. In contrast, current transactions involving mezzanine and other institutional subordinated debt typically provide the senior lender with the ability to implement a payment blockage against the subordinated lender for a specified period of time (generally set in the range of 90 to 180 days) for an event of default that does not involve the failure to make a payment on senior debt, and a permanent payment blockage for a default due to failure to pay all or any portion of the senior debt.

Complete payment or claim (debt) subordination provisions of an intercreditor agreement provide that the senior creditor will be paid prior to the junior creditor and require the junior creditor to turn over any payment received from a debtor, whether received from the collateral or otherwise, until the senior indebtedness is paid in full. Complete subordination therefore provides a significant inducement for the senior lender. It is not, however, uncommon for intercreditor agreements to be less than complete. In other words, subordination arrangements often permit some regularly scheduled payments to the subordinated lender; interest, principal or both; unless the debtor is in default. In the context of the common debtor’s bankruptcy, all of these payment or claim-subordination provisions entitle the senior creditor to receive all distributions allocable to the senior debt, along with all distributions allocable to the subordinated debt, until the senior debt is satisfied in full.[3]

B. Lien Subordination

Lien subordination means that one lender agrees that the priority of its liens on property that serves as common collateral will be subordinate to the liens of another lender. Subordinated secured lenders possess certain rights because of their status as lienholders that, in the absence of an agreement to the contrary, would interfere with the rights of senior lenders in workouts or bankruptcies. Typical lien subordination enables the senior lender to collect on the proceeds of its collateral before the subordinated lender, and the subordinated lender will agree to some short period of time before taking any foreclosure action against shared collateral. This is called a “remedy standstill” provision. The senior lender expects to be in the driver’s seat for a period of time (i.e., a range of 90 to 180 days) when it comes to dealing with, and exercising remedies against, the shared collateral.

The generally accepted principle is that the subordinated lender should be permitted to exercise remedies in the event that the senior lender fails to commence an exercise of its remedies after this standstill period. Acquirers may want to move forward with documentation based on their lenders’ mutual agreement that the second lien will be a “silent second” or that it will be “deeply” subordinated, but they do so at their peril. The meaning of both of those terms will vary from one deal to the next based upon numerous factors, including the composition of the senior and subordinated lender groups, the difficulty of syndicating those loans, the nature and value of the collateral for those loans, and the relative size of those loans. A deal can be delayed or sidetracked because of the lenders’ failure to agree on what each side meant by the use of those terms.

Remedies standstill provisions will normally be accompanied by terms that require the subordinated lender to turn over any amounts that it may recover in a liquidation or bankruptcy to the senior lender. This type of “turnover clause” is intended to prevent a subordinated lender from receiving more than it would have been entitled to receive under the intercreditor agreement. Turnover provisions involve drafting nuances that may fundamentally modify their effect. For example, if the intercreditor agreement were to permit the subordinated lender to foreclose at the end of the remedies standstill period, then the drafting of the turnover provision might permit a subordinated lender to argue that it should not be obligated to turn over to the senior lender any funds that it received following the end of the standstill period.

Lien subordination provisions of an intercreditor agreement define, and often alter, the rights and priorities of creditors’ liens in shared collateral and require the junior creditor to turn over to the senior lender proceeds received on account of shared collateral. The provisions of the intercreditor agreements that address subordination of the junior liens to those of the senior lender are not usually subject to significant negotiation.[4]

C. Structural Subordination

Structural subordination is a device frequently encountered in transactions involving mezzanine and other types of subordinated debt. Structural subordination means that the priority of payment of an obligation as a practical matter is determined by the structure of the financing transaction and the recipient of the loan rather than by any express contractual agreement by a lender to subordinate its priority. In the standard structurally subordinated financing, the senior lender would make a loan to the operating company that owns the assets that serve as collateral for its loan, while the obligor of the mezzanine lender’s loan would be a holding company that owns no assets other than the stock that it holds in the operating company.

Structural subordination can be achieved when indebtedness is incurred at different levels in the corporate family. For example, in the context of a parent-subsidiary structure, the debt issued at the parent or holding-company level can be structurally subordinated to debt issued at the subsidiary-operating company level since subsidiary-level creditors have first claim to the subsidiary assets while parent-level creditors are limited to a claim on the assets of the parent holding company typically consists of equity in the subsidiary. The issues for lenders at the subsidiary level in a structurally subordinated transaction include ensuring that there are adequate restrictions and protections in place with respect to intercompany dividends and transactions.[5]

D. Equitable Subordination

The bankruptcy laws enable bankruptcy courts to “sift the circumstances surrounding any claim” against the debtor or the bankruptcy estate in order to avoid unfairness in the distribution of assets.[6] Therefore, a bankruptcy court has the authority to subordinate claims in cases of inequitable conduct by the creditor. Providing that the court may “under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim….”).[7] Equitable subordination is typically appropriate if (1) the creditor engaged in inequitable conduct, (2) the inequitable conduct resulted in injury to creditors or conferred an unfair advantage, and (3) the subordination would not be inconsistent with bankruptcy law.[8]

III. Intercreditor agreements

Intercreditor agreements are used in a variety of financing transactions to establish the respective rights and remedies of two or more creditors in credit facilities provided to a common borrower. Intercreditor agreements are not standardized, and their scope varies widely. Intercreditor agreements may include payment subordination provisions, payment standstill terms, and other creditor rights and remedies that do not involve collateral. Such payment subordination arrangements are typically found in unsecured mezzanine financing, for example. In secured financing transactions, however, the intercreditor agreement may also govern the relative rights and priorities of each creditor’s liens in the borrower’s assets.

The past recent years have witnessed an increase in the use of “Subordinated-lien” structures in institutional senior secured syndicated financing transactions. These structures involve a “first lien” loan secured by a first priority lien in substantially all of the assets of the borrower, and a separate “second lien” loan, typically provided by a separate lender group, secured by a second priority lien in the same collateral. Subordinated-lien structures have enjoyed increased popularity in recent years because of the increased liquidity provided by Subordinated-lien lenders that might not have provided financing on an unsecured basis, and because of the relatively narrow interest rate spreads available in the second lien market before the financial crisis in the latter half of 2008.[9]

An intercreditor agreement is an agreement among creditors that sets forth the various lien positions and the rights and liabilities of each creditor and its impact on the other creditors. Intercreditor agreements are often used financing companies and lenders to determine relative rights of multiple creditors and establish priorities in payments and other issues. It is common for the intercreditor agreement to include buy-out rights that give the second lien lender the option to acquire, at par, the first lien lender’s claims and liens. That purchase option is typically triggered by specified events, such as the filing of a bankruptcy case by or against the borrower.

There are a number of provisions in intercreditor agreements that are designed to define the rights of lenders with claims against a common debtor and common collateral.

A. First lien caps

Subordinated-lien lenders often seek to negotiate caps on the total outstanding indebtedness to the senior, first-lien lender that will enjoy the benefit of the senior lien. The caps can take the form of an absolute dollar cap placed on the total amount of outstanding debt secured by the senior lien or couple the maximum senior debt limitation with separate caps on each component of the overall credit facility. Another way caps can be addressed is through provisions in the intercreditor agreement limiting or prohibiting the funding of additional term loans (or reloading outstanding loans) to achieve a reduction in the senior debt. One of the main purposes of these caps from the subordinated-lien lender’s perspective is to preserve perceived collateral value (i.e. equity) for the benefit of the junior creditor by placing contractual limits on the indebtedness subject to the senior, secured lien. From the senior lender’s perspective, a dollar cap may need to include a cushion to allow room for growth or over advances under the facility. In addition, reimbursement or payment obligations associated with indemnity obligations, interest, fees (including prepayment fees, termination fees, attorneys’ fees and enforcement expenses), bank product costs and other non-advanced sums arising under the credit documents or in connection with the banking relationship must be considered in order to ensure that such amounts are afforded senior lien status even though the aggregate debt might exceed any negotiated cap.

Subordinated-lien lenders may seek to limit or eliminate some of these “add-on” items to the negotiated dollar cap on senior debt. For instance, subordinated lenders challenging “add-ons” frequently take particular issue with the inclusion of enforcement expenses, indemnity obligations and default interest as priority debt. Senior lenders typically insist that even if the amounts owing by the borrower exceeds the negotiated cap, the debt nevertheless remains secured by the collateral and is subject at least to a waterfall provision in the intercreditor agreement that allocates collateral proceeds between the lenders. Careful drafting of provisions in intercreditor agreements that cap or limit the senior debt is necessary in order to avoid the loss of senior lien status since the incurrence or accrual of non-advanced amounts under the senior facility could otherwise cause the aggregate debt owed to the senior lender to exceed the dollar cap.[10]

B. Blockage payment

In a senior lender/junior lender scenario, the lenders will customarily enter into an intercreditor agreement to establish their respective rights when dealing with a common borrower. The intercreditor agreement will usually provide a restriction on the payments that the borrower can make to the junior lenders upon the occurrence of certain events of default under the senior lender credit agreement. These provisions are referred to as “payment blockage” provisions. If a payment blockage provision is triggered, all payments to the junior lenders will usually be blocked, even the payments the junior lenders may otherwise be entitled to receive, such as scheduled interest or ordinary course fees and expenses. Payment blockage provisions usually require some negotiation in an intercreditor agreement. The following elements should be considered: Triggering: when payment blockage will occur; e.g. more material events of default such as a payment default, a financial covenant default or an insolvency event; Blockage period: length of time the blockage will exist; e.g. no more than 180 days in any one year or once per year; Notice: whether or not notice is required to be given by the senior lenders to the junior lenders. Notice is most often required if the triggering event is a relatively less material designated blockage event of default.

It is important to note that, in the event that payments to the junior lenders are blocked, and the borrower makes payments to the junior lenders during the blockage period, the junior lenders will be required to pay any amount received from the borrower to the senior lenders pursuant to the “turnover” clause in the intercreditor agreement.

Unless the junior lien lender’s interest justifies “deep” subordination (e.g., complete, standstill subordination) due to the nature of the debt (e.g., seller financing) or the identity of the Subordinated-lien lender (e.g., insider or affiliate of the borrower) or there is an event of default under the senior credit facility, intercreditor agreements often permit the borrower to pay and the junior creditor to receive regularly scheduled principal and interest payments. The occurrence of a triggering event, such as a default under the senior credit facility or the borrower’s bankruptcy, typically precludes payment on subordinated debt. The central issue for negotiation is the “blockage period,” the length of time that payments should be barred before the junior lender is able to receive payment. There are also issues surrounding whether or not notice is required to be given by the senior to the junior lender in order to trigger a payment blockage.[11]

C. Reinstatement of obligations

Stipulations should be included in intercreditor agreements that revive the amount of senior debt previously paid and thought to satisfy the first-lien arrangement but are subsequently required to be disgorged or recaptured as a preferential or other voidable transfer. From the first-lien lender’s perspective, the terms of the intercreditor agreement should be reinstated to the extent any payment received and applied to the senior debt is later required to be disgorged. The second-lien lender typically resists a requirement to return proceeds that it received after discharge of the senior debt but before the first-lien lender is actually required to disgorge a voidable payment.[12]

D. No Contest of Liens

Intercreditor agreements commonly contain provisions to the effect that neither secured party will challenge the validity, perfection, or priority of the other’s liens in the shared collateral, except to the extent necessary to enforce the agreement itself. Most modern agreements also preclude the parties from encouraging or supporting the efforts of third parties to challenge the liens of the lenders.[13]

E. Liens Subject to Subordination

Subordinated-lien lenders often attempt to confine their subordination to those liens granted to the junior lenders under the credit documents evidencing the second-lien loans. Similarly, Subordinated-lien lenders attempt to restrict the liens to which priority is yielded to those liens of the senior lender that arise under the credit documents evidencing the senior loans. The senior lender will often insist that any lien it obtains, whether under the senior lender’s credit documents, a bankruptcy proceeding (e.g., replacement liens granted as adequate protection or under a DIP bankruptcy financing arrangement) or otherwise, should be superior to any lien obtained at any time by the second-lien lender. Any limitation or cap on the senior debt in the intercreditor agreement naturally places the nature and extent of the parties’ respective liens in issue.[14]

F. Validity and Priority of Senior Liens

Intercreditor agreements almost always contain explicit statements as to the validity and priority of the senior liens, notwithstanding the time, order, manner, or method of creation, perfection or priority of the respective security interests. Subordinated-lien lenders often request an exemption or carve out from lien subordination by conditioning lien subordination upon the validity, perfection, and non-avoidance of the liens of the first-lien lender with respect to the shared collateral. The rationale for the carve out is to preserve the perfected, but contractually subordinated, lien position of the Subordinated-lien lender in the event the senior lien is avoided in an insolvency proceeding as well as to fend off a bankruptcy trustee’s attempt to claim a superior right to the proceeds of the collateral to the extent of the avoided lien.[15]

G. Standstill Periods

Intercreditor agreements routinely require Subordinated-lien lenders to refrain from taking certain enforcement actions, notwithstanding the occurrence and continuation of defaults under their credit documents. In other words, junior lenders are required to forbear from exercising their rights and remedies under the credit agreements and applicable law for a mutually agreed upon period of time frequently referred to as a “standstill” or “standby” period. Since first-lien lenders often have the benefit of the cushion afforded by the collateral, they are more likely to give the borrower time to cure defaults or develop a plan for addressing the outstanding obligations (which may include bankruptcy). Subordinated-lien lenders typically have little, and often no, such cushion and would prefer to foreclose immediately; particularly if the value of the collateral is deteriorating. A significant issue for both senior and junior lenders is the duration of the standstill period. The standstill period, whatever its duration, should not begin until the senior lender receives written notice from the junior lender that an event of default has occurred and that the junior lender intends to start an enforcement action. Notwithstanding the expiration of the standstill period, most intercreditor agreements preclude the junior lender from commencing an enforcement action if the senior lender “diligently pursuing” such an action or is precluded from doing so by applicable law.[16]

H. Liens release

Parties to intercreditor agreements often include provisions in those agreements and the junior credit agreements addressing the circumstances under which the second-lien lender is required to release its liens in collateral securing the subordinated debt. As part of a restructuring or forbearance arrangement implemented after an event of default, it may, from both the borrower’s and the first-lien lender’s perspective, be desirable to make certain dispositions outside the ordinary course of business that are usually precluded under the credit agreements. A restructuring or liquidation plan outside of bankruptcy may be frustrated absent appropriate provision in both the intercreditor agreement and the junior credit agreement that eliminates the necessity for the junior lender’s consent in defined circumstances. As a measure of protection for the first-lien lender, the intercreditor agreement should also include an irrevocable power of attorney to enable the filing of lien releases in the event the junior lender refuses to do so. It is, however, important to recognize that lien release provisions are often resisted by Subordinated-lien lenders. Moreover, waivers in intercreditor agreements designed to protect the finality of a disposition of the collateral effectuated by first-lien lenders may not be enforceable.

Article 9 of the Uniform Commercial Code provides that certain obligations imposed on first-lien lenders may not be waived in advance, including the following: (1) requiring notification to second-lien lenders prior to disposing of the collateral, (2) requiring all aspects of the collateral disposition to be commercially reasonable, and (3) certain rights of the second-lien lender to object to strict foreclosure of the collateral.[17]

I. Cure Rights

Subordinated-lien lenders occasionally want to address cure rights with respect to defaults under the senior facility in the intercreditor agreement. The right of the subordinated lender to cure should be conditioned in a number of respects. First, only those defaults capable of cure, such as payment defaults, should be subject to such an agreement. Second, there should be defined parameters on the time within which the junior lender should be able to cure the defaults so that any cure period does not effectively operate as a forbearance period at a time when the senior creditor may need to take immediate action.[18]

J. Buyout Rights

In order to regain control in a default situation, Subordinated-lien lenders in certain circumstances seek to include in the intercreditor agreement the right to purchase the senior debt at par. Any buyout right is customarily made without representation, warranty or recourse (other than, perhaps, for due authorization).[19]

K. Cross Defaults

It is quite common for the senior and junior lenders to include cross default provisions in their respective credit agreements. The senior lender will undoubtedly insist upon such a provision in order to ensure an entitlement to act in the event the junior lender has the right to do so.[20]

L. Shared Credit Agreements

The use of a single credit agreement for loans made by first and Subordinated-lien lenders should be avoided. In addition to drafting complexities of a shared credit agreement, at least one court has viewed the separate lending positions as a unified, secured claim for bankruptcy purposes.[21]

M. Prepayments

First-lien lenders often seek to limit the ability of the borrower to prepay the subordinated, secured debt until the senior indebtedness has been paid in full. Provisions relating to prepayment are typically covenants addressed in the senior credit facility, a breach of which would constitute a default but would not necessarily provide recourse against the prepaid Subordinated-lien lender.[22]

N. Amendments

Senior credit agreements often restrict the borrower from making amendments to the junior credit agreements without the senior lender’s prior written consent. Particularly troublesome are amendments that increase the amount of principal, the rate of interest, the timing of payments, and the maturity of the loan or otherwise make the borrower’s performance more burdensome or otherwise adversely affect the position of the senior lender. From the senior lender’s perspective, agreements to lend and permit subordinated secured indebtedness were premised on a certain set of expectations that should not later be frustrated. Junior lien lenders similarly seek to restrict certain amendments to the senior credit agreements.[23]

O. Successors and Assigns

Both parties to an intercreditor agreement typically require the agreement to inure to the benefit of and be binding upon successors and assigns. Although successor and assignment clauses are customary and not usually controversial, more comprehensive arrangements include covenants requiring the Subordinated-lien lender to provide any assignee notice of the arrangement (and may in fact condition any assignment on the assignee’s acknowledgment of the intercreditor agreement). In order to impart notice to potential assignees, a first-lien lender should require the Subordinated-lien lender’s financing statements and other perfection documents to specifically provide that its debt and lien priority are subject to an intercreditor agreement. First-lien lenders should view negotiations of intercreditor agreements with a view towards a potential exist strategy (e.g., assignment); an unfavorable arrangement might adversely affect a third party’s desire to purchase the position in a distress situation.[24]

IV. Lien priorities and the effect of subordination agreements

How does a court decide Lien Priorities when more than one creditor has a security interest in the same collateral? A California case gives us the opportunity to study lien priorities and the effect of subordination agreements. Ordinarily real property liens have priority according to chronology; the oldest recorded lien is the highest in priority. This scheme can sometimes be altered by a subordination agreement, where a lender with an older, more senior lien, agrees to allow its lien to be junior to a more recently recorded lien. This is often done, for example, when a seller subordinates his purchase money lien to the lien of a construction lender, who will not loan unless it is assured of being in first position.

The case of Wells Fargo Bank v. Neilsen,[25] shows what can happen with careless handling of a subordination agreement, and how lien priorities are assessed when there is an intervening lien that is not subject to the subordination agreement. James Neilsen’s residence in San Mateo was liened by three Deeds of Trust (DOT). The First DOT to American Express Centurion Bank (AMEX) was recorded in January 2002. The Second DOT secured a loan from Wells Fargo (WFB) and was recorded in September 2002. The Third DOT was in favor of PHH Mortgage Corp. (PHH) and was recorded in November 2003. As part of the PHH loan transaction in 2003, AMEX subordinated its lien to PHH’s DOT, but neglected to acknowledge the intervening lien of WFB. Thus, PHH became senior to AMEX while remaining junior to WFB, and AMEX became junior to PHH while remaining senior to WFB.

In 2007, AMEX foreclosed, and the property was purchased at the sale by WFB, apparently anxious to protect its lien, the status of which was uncertain and possibly subject to elimination by the foreclosure of AMEX’s possibly senior lien. From the sale proceeds the foreclosure trustee first paid AMEX the $28,726 owed on its lien, leaving about $368,000 remaining. The lenders made competing claims to the money, and the Owner/Borrower Neilsen contended that the “surplus” was his because the lenders failed to clarify their priority. The foreclosure trustee filed a petition to determine the priorities.

The Trial Court held, and the Court of Appeal agreed, petition for review denied,[26] that PHH should be paid first, as a result of AMEX’s subordination, but only to the extent of AMEX’s lien (the amount WFB consented to be junior to, or subordinate to, when it made its loan). The original third priority lien moves to first position, but only to the extent of the lien that it is replacing. If it is smaller than the lien it is replacing, then the entirety of the lien moves into first position. If it is larger than the original first priority lien, then only so much of it as is equivalent to the original first priority lien moves into first position. Then WFB gets paid what it was owed, because it was originally subordinate to AMEX. Because PHH’s lien was larger than the AMEX lien that it was replacing, only $28,726 of it was bumped into first priority. Thereafter WFB remained in second priority, as it had consented to when it made its loan. The balance of PHH’s loan remained in third priority, but still ahead of AMEX because AMEX contractually subordinated.

Thus, the lien priority was resolved like this:

The Owner/Borrower got nothing, and his claim was rejected, and the decision was upheld on appeal.[27]

V. Conclusion

In the current environment, one should expect that senior lenders will insist on structures that maintain the sanctity and protection of a deep subordination. At the same time, mezzanine and other subordinated lenders will be looking for better pricing, an opportunity for supplemental equity returns and greater rights than Subordinated-lien lenders accepted during the frenzied credit environment that permeated from 2003 to 2008. Because of the conflicting goals of these two classes of lenders, a private equity group or other acquirer should convince its lenders to address intercreditor issues at an early stage in the deal negotiations in order to avoid potentially lengthy and costly delays when that deal is otherwise on the verge of consummation.

The lien subordination intercreditor issues discussed in this article represent a handful of the most important concepts negotiated between first lien and Subordinated-lien creditors. In addition to the issues treated here, there are a number of other issues of vital importance to first and Subordinated-lien lenders in this market, including those arising in the context of a bankruptcy proceeding of the borrower. Despite the current dearth of new Subordinated-lien financings, an understanding of these issues is both timely and critical to any financial restructuring involving lien subordinated debt. As recent examples have shown, the manner in which some of these issues were resolved in the drafting of the governing intercreditor documentation can have decisive impact on the recovery available to different classes of creditors, resulting in unexpected losses to some and potential windfalls to others.

Going forward, a clearer view of the conceptual framework underlying lien subordination, and of the key issues that require close attention in the negotiation and drafting of intercreditor documentation, will be of practical benefit to transactional practitioners, as well as to other parties, such as courts, that may be called upon from time to time to interpret or implement intercreditor arrangements.

In Wells Fargo Bank v. Neilsen; when reordering the priorities of liens, a first and a third position lender cannot make an agreement that changes the risk that a second position (intervening) lender agreed to accept when it made the loan. The second position lender cannot be bumped lower in priority as a result of an agreement that it did not participate in. As we can ask: Did these institutional lenders not think to order a Preliminary Report and purchase a lender’s policy of title insurance, insuring their priority?

* José Francisco Gierbolini Bonilla es abogado, profesor de derecho, estratega político y especialista en cumplimiento normativo con más de 25 años de experiencia en el sector legal y financiero. Actualmente lidera SCAP Broker como CEO, aportando su visión estratégica y su profundo conocimiento en regulación financiera, gestión de riesgos y estructuración corporativa internacional. Cuenta con un LL.M. en Derecho Internacional, Compliance y Servicios Financieros de la Thomas Jefferson School of Law en San Diego, California; además de un Juris Doctor Magna Cum Laude de la Universidad de Puerto Rico. También posee estudios avanzados Máster en psicología industrial y una licenciatura en bioquímica, lo cual le permite integrar el análisis humano, jurídico y técnico en la toma de decisiones.
Está admitido para litigar ante la Corte Suprema de los Estados Unidos, SCOTUS, Primer Circuito de Boston y múltiples cortes federales y tribunales administrativos en Colorado, Puerto Rico y Florida. Ha ejercido como abogado litigante y asesor desde su firma Juris Zone Law Offices PSC. Es autor de varias publicaciones académicas en derecho comercial, bancario, propiedad y lavado de activos, y ha sido citado por el Tribunal Supremo de Puerto Rico por sus aportes doctrinarios.

[1] Hardwicke v. Hamilton, 26 S.W. 342, 345 (Mo. 1894).

[2] See George H. Singer. The Lender’s Guide to Second-Lien Financing, 125 Banking L.J. 199 (2008).

[3] Id.

[4] See Robert L. Cunningham & Yair Y. Galil, Lien Subordination and Intercreditor Agreements, 25 Rev. Banking & Fin. Services 49 (2009).

[5] Singer, supra note 2.

[6] Pepper v. Litton, 308 U.S. 295, 208 (1938).

[7] 11 U.S.C. § 510(c) (2012).

[8] In re Clark Pipe & Supply Co., 893 F.2d 693 (5th Cir. 1990).

[9] See Committee on Commercial Finance, ABA Section of Business Law. Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force, The Business Lawyer, Vol. 65, No. 3, 809-883 (2010).

[10] Id.

[11] Singer, supra, note 2.

[12] Committee on Commercial Finance, supra note 9.

[13] In re ION Media Networks, Inc., 419 B.R. 585 (Bankr. S.D.N.Y. 2009),

[14] Singer, supra, note 2.

[15] Id.

[16] U.C.C. §§ 9-315, 9-617 (2023).

[17] U.C.C. §§ 9-602, 9-620, 9-625 (2023).

[18] Singer, supra, note 2.

[19] Id.

[20] Id.

[21] In re Ionosphere Clubs, Inc., 134 B.R. 528 (Bankr. S.D.N.Y. 1991).

[22] Singer, supra, note 2.

[23] Id.

[24] Id.

[25] Wells Fargo Bank v. Neilsen, (First Dist. Ct. of Appeal, No. A122626, Oct. 22, 2009) 2, DAR p.15084.

[26] Wells Fargo Bank v. Neilsen, 2010 Cal. LEXIS 991 (Fl, 2010).

[27] Peter N. Brewer, Lien Priorities and Subordination Agreements, Brewer, October 22, 2009, https://www.brewerfirm.com/resources/lien-priorities-and-subordination-agreements/.