Large projects require significant funding that is served through debt financing. Corporate institutes, banks, and creditors fund these large projects in tandem. The risks of default of the borrower or project failure are significant in such scenarios. Creditors may find it difficult to prioritize the claims to collateral in such a scenario. An intercreditor agreement solves the issues between two or more creditors having a common borrower.
An Intercreditor agreement describes a legal agreement between two or more lenders defining the rights and obligations with their common borrower and collateral assets.
Broadly the intercreditor agreement will include the borrower’s total assets, not just the collateral. Default to a large debt financing may result in the bankruptcy of the borrower. Creditors settle their rights in an intercreditor deed in case their borrower goes bankrupt.
What is an Intercreditor Agreement?
If there are only two lenders for a large project and they have the same borrower, they can settle it through debt prioritization. A senior debt would hold an upper hand in legal terms over a Junior or Subordinate debt. Having more than two creditors and a mix of Government and private entities create the complexities of Debt financing.
Debt prioritization would only result in ranking the repayments. An intercreditor deed seeks legal rights over the assets and prioritizes the lien rights. A lender with senior debt and funding a significant portion of total financing would seek greater control. The agreement would also include the interest payment priority as agreed by the creditors.
Some key points included in an Intercreditor Agreement can range:
- Debt seniority and prioritization in case of the borrower’s default.
- Legal rights of the senior lenders and their subordinate debt terms.
- Rights to repayments in case the borrower’s repayment powers diminish.
- Limiting the subordinate lenders for legal actions against the senior lenders.
- Rights to the lien, asset liquidation, and priority of claims over other assets.
Borrowers do not need to be involved party in an intercreditor agreement. However, in certain cases, borrowers must involve in an intercreditor agreement as well.
Why an Intercreditor Agreement is Required?
An obvious reason to form a legal agreement is to secure the rights of the lenders. In the absence of any formal agreement, there can be no principled stance and the claims on borrower’s assets would never settle.
The situation can further complicate if more than two parties issue equal financing in the same project. Prioritization of creditors in such cases couldn’t be agreed upon without a legal documentary agreement. Similarly, if both Government and private-sector creditors are involved, the borrower’s prioritization may not be acceptable for creditors.
Debt prioritization may also depend on the borrower as well. A government institute backed by government resources may easily arrange an intercreditor deed than a private sector borrower.
Creditors with subordinate and junior debt remain largely at disadvantage even with a formal agreement. In the absence of a legal document, there would hardly be any subordinate debts. Senior debt is considered a secured form of a loan. Interest and other debt service costs with a secured loan are lower than an unsecured loan. In this sense, an intercreditor deed serves to the benefit of the borrower as well.
Challenges with Intercreditor Agreement
A borrower may find it difficult to fund a large project without a legal agreement between its creditors. Debt prioritization would also affect the borrower’s cost of borrowings.
Junior lenders find themselves at disadvantage even with a legal agreement. They must seek to balance the power-sharing and secure their rights as much as possible. A senior lender holds the right to lien because they fund a large portion of the project.
Let us take a glance at some key challenges for the creditors.
Classification of Senior and Junior Debts
The proportion of the total funding size may become the starting point in prioritizing the debts. A senior debt holds the right to lien and assets owned by the borrower. The borrower would be interested to negotiate the interest rates after deciding on the senior lender.
Junior debts fall behind the senior lenders in lien rights. The junior lenders look to compensate for their disadvantage with higher interest rates. However, the practical implications of entering into a junior debt can be significant. The senior lenders dictate the intercreditor terms that make it difficult for junior lenders to approve subordinate debts.
Priority over Scheduled interest payments
Senior creditors pressing for priority over scheduled interest payment is also a common phenomenon. Senior creditor enforces limits on scheduled payments to subordinate loans if the borrower’s capabilities diminish over time.
A useful strategy for junior lenders would be to include the limitation or blockage conditions in delayed form. Junior lenders may also seek inclusion for repayments over other obligations such as dividend payments.
Defining asset classes as Collateral
The borrower would pledge a common asset or class of assets to the same creditors. That leads to the need for the intercreditor agreement in the first place. A senior lender would appraise the market value of the pledged asset and approve the loan.
A useful tactic for junior lenders can be to ask for the rights over other assets owned by the borrower in case of default. They must seek exemption of these assets from the lien claims by the senior lenders.
All creditors must also carefully negotiate and understand other common regulations. Some creditors may seek debt financing with representation rights in the borrower’s board as well.
Lawsuit Priority with Intercreditor Agreement
The prime objective of entering into an intercreditor agreement is to settle the litigation claims over default. A senior debt holds priority over junior debt. In the undesirable event of the borrower’s liquidation or bankruptcy, the lenders hold preference over shareholders. The senior debt needs to be serviced in full before settling any other claims in liquidation scenarios.
Once agreed formally, the senior lenders may seek representation in the borrower’s board room as well. In some cases, senior lenders enforce a limitation on seeking further subordinate loans by the borrower.
An intercreditor agreement settles the debt prioritization and legal rights of the creditors. Creditors to a common borrower seek legal protection for their debt repayment rights. A borrower’s keen interest would be to secure project funding at relevant interest costs with secured and unsecured loans by entering into an intercreditor agreement.