LEGAL CHANGE

Plan your intercreditor arrangements more effectively by using musical concepts

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In this issue

About the author

Stephan Smoktunowicz is a banking & finance partner at the London office of the international law firm, gunnercooke. He helps businesses & people in the UK and across the world to achieve their commercial objectives and safely navigate issues that arise throughout any transaction lifecycle. He also provides training and mentoring to businesses, professionals and students on related topics.

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Prelude – the work before the concert

Getting any agreement drafted effectively requires careful up front thought. But failure to identify your key outline commercial terms before instructing lawyers can create extra questions, time delays and increased costs.

Where a transaction or capital structure involves different layers of financing or debt, individual financiers/creditors will typically produce term sheets for the underlying loan/finance agreement. This makes the drafting process a whole lot simpler.

However, thoughts may not necessarily turn to details of intercreditor arrangements from the outset. In addition to adding to time, work and costs, failure to have a feel for what your intercreditor should cover at the outset could also result in dangerous oversights and your business taking on undesirable commercial risk.

Getting prepared for the gig

But just as an orchestra rehearses before giving a concert to get a feel for the music, the concert hall environment and how everything sounds, financiers/creditors can prepare for the documentation process by first assessing and getting a real feel for the issues that could impact them throughout the life of an intercreditor agreement and formulating how they wish to approach them.

In turn, this thought and planning can provide a clear basis for what is needed in the intercreditor agreement when it is drafted, which can make the drafting and subsequent review and negotiation of the intercreditor a far less protracted process.

So, with that in mind, let’s take a look at five musical concepts that can help financiers/creditors to formulate their pre-drafting approach and help save time and cost during the transaction process.

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1. What’s your orchestra?

If you take any company with multiple sources of finance, each finance package may vary.

For example:

• the different financiers (or departments of a financier) in each case
• each type of finance arrangement (e.g., loan/asset finance/receivables finance/interest rate swap)
• the security and/or guarantees given to each financier (e.g. all asset security, asset specific security, or all monies or limited recourse guarantees)
• the geography of the company and each financier
• other creditor types (e.g., a seller of shares taking deferred consideration, a pension fund, or a machinery supplier)
• the interplay with other companies in the borrower’s/debtor’s group and how that group may change over time.

Why is clear identification of the orchestra important at the outset?

When a composer is writing a piece of music, they will need to identify which instruments will be members of the orchestra at the earliest opportunity, because:

• the combination of instruments will affect how the piece actually sounds
• if the composer starts writing the piece and then wants to add extra instruments into the mix, that will add time and cost to the process and may impact the quality of the final composition.

Furthermore, if the composer wants to make a profit from their work, not factoring in extra instruments and musicians at the outset could eat into revenues and profitability.

An intercreditor agreement is really no different

All relevant creditors and debtors and layers of debt, security and guarantees should be identified at the outset (including those that could come into the fray down the line). Failure to do so could allow important strands of debt or collateral to fall through the net and in any event, each strand will create different considerations.

Thoughts should also turn to whether and how the make up of the ‘orchestra’ at day one should be allowed to change or evolve during the lifetime of any financing/debt and its impact on relevant creditors and debtors.

That process is not only beneficial for mapping out the intercreditor, but also for sense checking how restrictions in the underlying facilities/credit agreement work and whether the intercreditor is to be designed as a ‘one size fits all’ agreement catching a range of expected scenarios and bringing in extra parties where needed, or whether additional intercreditor agreements will be needed at day one or down the line to deal with additional strands of debt or collateral.

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2. Who are your soloists?

Without changing its texture, music can become stale, lifeless and boring. So giving prominence to solo instruments gives the chance for different performers to shine and makes the music more interesting and colourful.

For example, the start of Gershwin’s Rhapsody in Blue lets the clarinet flourish. Contrast that with Vivaldi’s Four Seasons, where the violin is really centre stage throughout.

Who are you letting shine in your intercreditor & when?

Intercreditor agreements also contain soloists – for example:

• a creditor whose security ranks ahead of all other creditors’ security given by the same debtor will usually take the lead on enforcement and be able to trace into security enforcement realisations ahead of other creditors – i.e. that creditor effectively becomes the soloist when the possibility of enforcement becomes a reality
• you might have a number of soloists at the same time – for example creditors who are allowed to receive permitted payments from debtors if certain conditions are met
• where one creditor seeks consent to increase its lending amount or obtain the benefit of new guarantees or security, another creditor may be the soloist who comes to the fore and has to consider whether to agree to that.

Ultimately, intercreditor agreements are all about the control of cash flows and identifying your soloists – i.e. who gets to turn on the money tap, to what extent and when and the factors that provide access to cash, both directly and indirectly.

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3. Achieving good harmonic and rhythmic structure

Music which has a good harmonic and rhythmic structure will sound coherent throughout. Take Johann Sebastian Bach’s famous Passacaglia – a composition which evolves magnificently and is structured both rhythmically and harmonically in flawless fashion from beginning to end.

Creating harmony across intercreditor layers

Intercreditor agreements often deal with complex layers of debt, security and guarantees. And how each creditor’s debt, security and guarantees evolve, mature and intertwine throughout a financing life cycle and how cash is released to creditors need to be perfectly judged to achieve the right balance of freedoms and protections for creditors and debtors.

An intercreditor which provides a good harmonic structure might for example, allow sufficient flex for payments contemplated at day one to be made uninterrupted to all creditors, balanced against any necessary controls/protections which prevent undesirable material cash dilution.

Similarly, an intercreditor might rhythmically bring a pause to any planned enforcement action by a mezzanine/junior creditor to allow senior creditors sufficient time to assess things and amend facilities, refinance or take other necessary action to shore up their position.

Take a step back to avoid a cacophony of sound

Understanding the composition of each debt and collateral layer in granular detail and how they might be changed, adapted and used by individual creditors allows a creditor to assess and build in any necessary intercreditor controls and protections.

And importantly, it helps to avoid a potential free-for-all which could undermine the overall capital structure and impact the harmony of the parties down the line.

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4. Who is your conductor?

Great musical performances often depend on great leadership – and the conductor of an orchestra can have huge influence over how the musicians play together. And in the rare event that things come undone on stage, a great conductor will quickly help the musicians to get things back on track.

Who’s conducting your intercreditor?

Similarly, when all is going well with a company’s finances and cash flow, the intercreditor may never need to be looked at. But if problems arise or things need to be addressed, the intercreditor needs to be structured in a way that underlying issues can be examined and addressed coherently.

Ultimately, that means that someone will need to be in the driving seat (and be happy to be in that driving seat). And their role in that driving seat will need to be carefully defined and understood so that not only can that role be conducted with flexibility and freedom, but also so that the role is recognised appropriately.

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5. Coda

Dvorak’s famous Slavonic Dances often contain ‘codas’ – the ending which adds a dash of extra excitement to each dance, creating a rousing finish.

If all goes well with an intercreditor, it may not need to be touched, but parties may still need to plan for that little bit of ‘extra music’. Amendments, waivers, changes to parties, super-priority positions, flex to include extra debt, or extra documents. This can raise important questions. What is their impact? How will they affect you as creditor?

Don’t let your Intercreditor coda be a mere afterthought

For that to all work effectively, it needs to be safely knitted within the composition of your intercreditor orchestra, your soloists, your layers of intercreditor rhythm and harmony and your conductor(s). And taking what you may have used on a previous transaction or what a precedent or previous agreement says may not necessarily work.

Ultimately, just as writing a musical score requires preparation and inevitably re-working in places, an intercreditor arrangement requires the same approach. Carefully identifying, preparing and working through each individual layer and strand of debt and collateral up front so that they can be weaved together harmoniously into the final agreement.

Not only will that minimise unnecessary waste during the documentation process, it will also ensure that you have carefully considered your commercial intentions up front and helped to mitigate the risk of unwanted things slipping through the net.