In this turbulent economic environment, there are an increasing number of loans going into default. Lenders may be requested to forbear from exercising their remedies and to participate in debt restructurings better known as “workouts.” In connection with a workout, an unsecured lender may be offered a second lien position on a debtor’s real estate or personal property assets in order to “collateralize” its unsecured debt. Even if the second lien attaches to equity in the collateral today, the lender may not have meaningful remedies if, down the road, it must foreclose on its second lien.
The first matter a second priority lender should consider is whether the first priority lender’s agreement with the debtor prohibits the debtor from granting any additional liens against the collateral. If so, taking a second lien may trigger a default under the debtor’s loan with its first priority lender. First priority lenders typically prohibit subsequent liens for a number of reasons, including that they do not want a subsequent lienholder interfering with their collateral. In the event of a default, the first priority lender wants to be the sole decision maker of when a debtor’s assets get liquidated (which usually signifies the shutting down of the debtor’s business) and does not want to have any duty to answer to a junior creditor. Sometimes additional capital infusions are welcomed by a first priority lender, and the first priority lender may consent to the granting of the subordinate lien. In that circumstance, the first priority lender and the second priority lender will typically enter into an “intercreditor agreement” which, among other things, addresses their relative collateral priority rights and under what conditions each lender may exercise its remedies.

If a second priority lender determines that its second lien attaches to equity in the debtor’s assets and is not prohibited by the terms of the loan with the first priority lender, it must consider what it will end up with in the event the debtor defaults under the restructured loan and the lender faces foreclosure of its lien. Chances are that if the second priority lender’s loan is in default, then the first priority lender’s loan is also in default. In that case, any equity the second priority lender may have had in the collateral may be quickly eaten up by the first priority lender’s default interest rate, collection expenses, and fees accruing with respect to the first priority lender’s loan. Furthermore, if the first priority lender brings a foreclosure action against the shared collateral and there is not sufficient equity to fully satisfy the second priority lender’s lien, the second priority lender will be faced with the decision of whether to buy out the first priority lender’s debt (sometimes called a “redemption”) or to have its lien in the asset “foreclosed out.”

If the first priority lender has not commenced a foreclosure action, and if the second priority lender still has equity in the collateral and chooses to foreclose upon the debtor’s default, it will only be able to “foreclose out” the debtor’s ownership interest in the asset and any liens junior to its lien. However, the second priority lender will not be able to foreclose out the first priority lender’s lien. At the conclusion of a successful foreclosure action, it or the successful bidder will own the foreclosed asset subject to the first priority lender’s lien. Therefore, the impact that the unaffected first priority lien will have on the value and marketability of the foreclosed asset should be carefully considered by the second priority lender. Although a second lien may adequately secure a second priority lender’s debt in certain situations, in other scenarios the lender may be well advised to have multiple exit strategies and to take a second lien only in conjunction with other security devices.

For more information, please contact Seth L. Cooper at slcooper@brodywilk.com.