Collateral Security and Intercreditor Issues

By: Linda Curtis and Andrew Cheng, Gibson, Dunn & Crutcher LLP.

ACQUISITION FINANCINGS INVOLVE CERTAIN COLLATERAL security and intercreditor issues, including:

• The extent and perfection of collateral security for the borrowing
• The scope of guarantees (and collateral security) from multiple members of an affiliated corporate group
• For deals involving multiple tranches of financing, intercreditor issues regarding lien and claim priority

While these collateral security and intercreditor issues are not unique to acquisition financings (indeed, they apply to all types of debt financing), there are certain aspects that may be the subject of particular focus in acquisition financings. See generally the topic Security Interests and Article 9 of the Uniform Commercial Code.

Collateral Security Issues

For example, it is not uncommon for a business enterprise of any size to include numerous foreign and domestic subsidiaries as part of the financing structure. Some of these subsidiaries may be wholly owned by the parent company and others may be majority owned with minority third-party business partners. When the corporate group is acquired, which of these subsidiaries should be required to give guarantees of the acquisition financing debt, and which of these subsidiaries should be required to grant collateral? Lenders typically want to include as many subsidiary guarantors and as much collateral as possible, but most entities, particularly enterprises with foreign subsidiaries, will require certain exclusions to prevent adverse tax issues. See Security Structures and Controlled Foreign Corporations Rules.

Also, leveraged acquisition financings may run into non-tax-related legal impediments for downstream entities issuing guarantees and granting security. An acquired business may have numerous subsidiaries that do not benefit (either directly or indirectly) from the acquisition financing, as most of the proceeds are usually given to the sellers of the business. The provision of guarantees and collateral from such subsidiaries are subject to fraudulent transfer concerns as a subset of the general issues regarding fraudulent transfers and leveraged buyouts. For more information regarding fraudulent transfers, see Fraudulent Transfers and Related Doctrines, also see Understanding and Analyzing Various Bankruptcy Issues and Bankruptcy Issues Related to Guaranties. In addition, there may be other restrictions on such guarantees and collateral under applicable law, including financial assistance and corporate benefit doctrines.

It is important to note that in acquisition financings there are timing issues regarding issuing guarantees and granting security interests, even where otherwise permissible under applicable law. Upon the closing of an acquisition, it is not uncommon for the officers and directors of the target’s subsidiaries (as well as those of the target) to change, so it may be impractical for the prior directors and officers to authorize and execute all of the required collateral documents. For this reason, many acquisition financings permit delays in issuing guarantees and granting liens in certain types of collateral for acquired subsidiaries. Thirty to ninety days after the closing of the acquisition—and sometimes longer for real property collateral—is a common range. See Conditionality in Acquisition Financing Commitment Papers — SunGard Provisions – Collateral and Guarantees.

Intercreditor Issues

Intercreditor issues in acquisition financings arise because a common structure for acquisition financings includes multiple tranches of debt with different priorities in the capital structure of the borrower group. As in any intercreditor situation, subordination may take the form of structural subordination, lien subordination, and/or payment subordination.

One key issue related to intercreditor arrangements in acquisition financings that arise more than in other types of financings, such as refinancings, is the issue of timing and certainty of funds. Intercreditor issues can be particularly complex and time consuming to negotiate. Unlike the granting and perfection of security interests in particular types of collateral, practically speaking, intercreditor issues are too important and on the forefront of most lenders’ agendas to push to a post-closing matter. Accordingly, it is particularly important for all parties in an acquisition financing to focus on and resolve intercreditor issues early in the documentation process. For this reason, it may make sense for certain of the intercreditor points to be fleshed out in the financing commitment papers rather than deferring them to the final financing documentation. And, although the private equity investor or buyer may have little interest in the actual substantive resolution of the intercreditor issues, they will be keenly focused on the parties reaching an expedient resolution.

Holding Company Structures

Many lenders prefer, or even require, so-called holding company structures in leveraged acquisitions. A holding company structure is one in which the ultimate equity owner of the corporate group is a holding company with no operations or assets other than the equity of the operating subsidiary. If there are multiple operating subsidiaries, a common structure is for the holding company to own only the equity of the principal operating subsidiary, with such principal operating subsidiary directly or indirectly owning the equity interests in the group’s other subsidiaries.

A holding company structure enables the senior secured lender to take a lien on 100% of the equity of the operating company. The lender typically requires receipt of the stock certificate at closing with an undated but signed stock power. Upon an event of default, the loan documents typically permit the lender to foreclose on the stock. Foreclosing on the value of the business as a going concern is much easier than being forced to exercise remedies on various assets of the business, which may be in different locations and subject to differing legal regimes.

The holding company structure may also offer advantages to the borrower and, if applicable, its ultimate private equity owners. With two holding companies, the lower level holding company can provide the stock pledge of the operating company referred to above, with or without a holding company guaranty. If the upper level holding company is excluded from the loan party group (so that it is neither a guarantor nor a pledgor), then the private equity owner may have desired flexibility to add businesses and incur structurally subordinate debt at the upper level holding company.

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