Avoiding a mezz and getting intercreditor drafting right – Lessons from case law

Despite attempts by some market participants to establish one, there is no standard market position for intercreditor terms in Australia.  

This means documentation can vary between transactions and documentary positions have potential to creep as deal precedents are re-used and amended in subsequent negotiations.  

With increasing activity from private credit funds and the emergence of new players in the Australian market, it is critical to get the structuring and documentation right when negotiating intercreditor terms on multi-tiered debt transactions.

This article reflects on three relevant cases to consider how courts interpret intercreditor provisions and explore the lessons for transaction counsel when preparing and negotiating documentation for new money deals.

Key takeaways:

1. Courts will apply a literal interpretation to intercreditor provisions
2. Relying on broad wording to infer a priority in a liquidation or distressed situation is unlikely to work – drafting should be express and clearly capture the intention
3. When a junior lender is clearly out of the economics, senior lenders will have significant flexibility if the intercreditor provisions are clear

Case 1 - JP Morgan v ANZ

Case Lesson – if intercreditor terms are to have effect in restructurings involving more than just regulating the priority between two existing debt claims, the intercreditor terms need to clearly say so.

A notable Australian case in this area is J P Morgan Chase Bank NA v Australia and New Zealand Banking Group Ltd¹  (JP Morgan Case).  The case related to the rights of a group of senior creditors to require that a junior creditor vote in support of a scheme of arrangement supported by the senior creditors.  

The key facts were:

1. JP Morgan and other parties were holders of bonds issued by a corporate issuer.
2. The bondholders were party to an intercreditor deed with senior lenders.  The bondholders were the junior creditors under this intercreditor deed.
3. ANZ was the Senior Agent and Senior Representative under the intercreditor deed.
4. The intercreditor deed contained a number of relevant provisions which were intended to create the priorities.  Importantly, the intercreditor deed contained a provision which prevented the bondholders from exercising voting rights in relation to insolvency processes other than in accordance with the instructions of the senior lenders except to the extent the senior lenders’ instructions would unfairly compromise the rights of the junior creditors in a manner beyond that contemplated in the intercreditor deed.
5. A restructuring through two schemes of arrangement was proposed and supported by the senior lenders.  One scheme dealt with the senior creditors and the other with the junior creditors.
6. Under the terms of the scheme relating to the junior creditors, junior creditors would receive a limited return (less than two cents on the dollar) and the remaining junior debt would be extinguished.
7. The junior creditors opposed the schemes.
8. The senior creditors sought to compel the junior creditors to vote in favour of the schemes.

The court held that the junior creditors were not compelled to vote in favour of the scheme.  The decision turned on the drafting of the intercreditor deed.

The reasons given included:

1. The intercreditor deed had the purposeof regulating the priorities of the senior and junior creditors while both thesenior debt and the junior debt were outstanding.  This was the result of the specific draftingin the intercreditor deed.
2. Under the proposed schemes the debts would cease to exist and there would be no ongoing purpose for the intercreditor deed, as regulation of the senior and junior debts would not be required.  A directive of the senior creditors to vote in favour of the schemes extended beyond the powers given to the senior creditors to instruct voting by the junior creditors under the intercreditor deed, as the intercreditor deed contained an exemption to the extent such instructions would unfairly compromise the rights of the junior creditors in a manner beyond that which is contemplated in this Deed.
3. In this sense, the contemplation of the intercreditor deed was to regulate existing priorities, not regulate the extinguishment of the debts owed.
4. Accordingly, the exemption in the drafting applied as the vote related to matters beyond the contemplation of the intercreditor deed.

This appears to be a case where a generic drafting catch all was agreed upon in negotiation and the wording ultimately had an unintended consequence when the transaction became distressed and restructuring solutions were being pursued.  The case is a practical reminder of the importance of precision and care when drafting and negotiating intercreditor documentation.

Case 2 – Re Bluebrook Ltd

Case Lesson – a clearly drafted intercreditor will facilitate a complex senior lender driven restructuring.

An interesting contrast to the JP Morgan Case is the English judgment in Re Bluebrook Ltd².  

In this case it was held that a junior creditor’s interests could be disregarded when considering a scheme of arrangement relating to a company with a valuation at a level giving no economic interest to the junior creditor.

The relevant intercreditor provisions in the Re Bluebrook case were, however, clearly stated to permit the deemed release of security and transfer of assets required to give effect to the proposed restructuring.  

Those clearly drafted provisions enabled the senior lenders to push ahead and implement their desired restructuring outcome.

The key facts were:

1. A group of senior lenders had made loans available to a group holding company secured over group assets and supported by guarantees from certain subsidiaries.
2. One of the guarantor subsidiaries had incurred a mezzanine facility from a group of junior lenders.  The junior lenders also benefitted from security over group assets.
3. The ranking of the senior and junior lenders was set out in an intercreditor agreement.  The intercreditor agreement contained the following provisions:
   • a statement that senior debt ranks first and junior debt ranks second;
   • a restriction on the junior debt being paid until the senior debt is paid;
   • a turnover clause requiring the junior lender to pass any amounts received to the senior lenders;
   • a right in favour of the security agent to release security and liabilities in respect of enforcement action provided the proceeds are applied in accordance with the terms of the intercreditor agreement;
   • a buy-out right in favour of the junior lenders enabling them to compel the senior lenders to sell the senior liabilities to the junior lenders if the junior lenders do not support senior lender enforcement action;
   • a clear provision that on an insolvency event (including a winding up or administration) the junior debt is subordinate in right of payment to the senior debt; and
   • a payment waterfall provision providing for proceeds of enforcement action to be paid to the senior creditors in priority to the junior creditors.
4. Valuations were presented which demonstrated that the junior creditors were out of the money and unlikely to receive any return on enforcement or through a winding up.
5. A restructuring via three related schemes of arrangement was proposed.  Under the schemes, the assets and operations of the group would be transferred to a newly incorporated holding company.  The senior lenders would be issued equity in that company and a portion of the senior debt would be novated to the holding company.  The restructuring required the use of the enforcement mechanics in the intercreditor agreement to compulsorily release security and guarantees held by the junior lenders to enable the transfer of secured assets to a newly established holdco of the restructured group.
6. The junior lenders objected to the restructuring as they would not receive any interest in the restructured group.  The junior lenders’ legal rights would be unaffected as they would still have a claim against their existing borrower.  However, they would be left behind as that borrower would no longer have an operating business (as the operating business would be transferred to the new group).  The junior lenders claimed that the schemes were unfair as they would be adversely affected, even if their legal rights would not change.

The judgment turned on whether the junior creditors could demonstrate the unfairness of the proposed schemes. The court accepted evidence that the valuation of the group was low and that the junior lenders had no prospects of receiving any return in an enforcement scenario (which was accepted as being the only alternative to the schemes).  The court also noted that the junior creditors had not exercised their rights to buy-out the senior debt, which they could have done under the terms of the intercreditor agreement.  Accordingly, the court found that the junior lenders were not able to establish the unfairness argument based on the prevailing facts and evidence presented.

Once the court had made this determination, the clearly drafted (and not disputed) provisions in the intercreditor agreement could be relied on to compel the release of guarantees and security that had been granted in favour of the junior lenders.  The intercreditor agreement was, in this case, drafted in a way which permitted the enforcement action required to give effect to the restructuring.

The difference in outcome between this case and the JP Morgan Case is notable.  The drafting of provisions in the intercreditor agreement were central to both outcomes.  In one case, the senior lenders were able to implement a scheme to restructure a distressed group without regard to the junior lenders.  In the other, junior lenders were found to be in a position to vote against a scheme supported by the senior lenders.  The importance of getting the drafting of intercreditor terms right and contemplating possible outcomes in a distress scenario should not be underestimated and is a point to focus on during deal execution.

Case 3 – CPF One Ltd & Anor v OSF (UK) II Ltd & Anor

Case Lesson – if a junior creditor wants the senior creditors or security trustee to owe them specific duties in a distressed situation the intercreditor terms need to expressly and clearly say so.

Another recent English case which turned on intercreditor drafting was CPF One Ltd & Anor v OSF (UK) II Ltd & Anor.³  

The intercreditor terms in this case were set out in a security trust deed.  The security trust deed contained a number of provisions giving the senior creditors the right to direct and instruct the security trustee.  The rights included rights to instruct the security trustee following breaches by the borrower.  The junior creditors were not given any equivalent rights and the security trust deed contained a provision expressly stating that the security trustee was not obliged or required to act in accordance with the directions of any creditors other than the senior creditors.

As settlement for all outstanding debt, the security trustee accepted a payment from the borrower that was slightly less than the amount then owed to the senior creditors.  This left the junior creditors out of the money with no return.  The junior creditors argued that the senior creditors owed them a duty akin to that owed by a first mortgagee to a second mortgagee.  However, the court did not agree with that argument for two main reasons:

(a)  the junior creditors did not hold a second mortgage, rather they had agreed contractual terms documented in the security trust deed which gave them a second ranking position in respect of a single security interest held by the security trustee; and

(b) in any event, the duty of a first mortgagee to a second mortgagee is a limited duty to obtain the best price reasonably achievable in the circumstances once a decision to sell has been made and not a broad duty to always take into account the interests of the subsequent mortgagee.

Based on the documents and facts before the court, the junior creditors could not establish that the senior creditor owed them any duty.  Rather, based on the documents, it was clear that the security trustee was permitted to act on the instructions of the senior lenders.  If the junior creditors wanted to be placed in a position akin to a second mortgagee, they should have expressly stated that in the intercreditor provisions and placed contractual obligations on the security trustee to treat them in that way.  Again, this is a lesson in the importance of making sure the intercreditor terms clearly state the parties’ intentions and contemplate various possible scenarios that could arise should the transaction become distressed.

For more information or assistance, please contact our Banking and Finance team.

¹ [2011] NSWSC 1359

² [2009] EWHC 2114

³ [2023] EWHC 2102

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