An intercreditor agreement is an agreement between two or more lenders that outlines their relative rights to shared collateral. In other words, it governs the lien priority and relative rights of two or more different groups of creditors to the same collateral. These groups of creditors are often referred to as the first lien lenders and the second lien lenders. A lien is simply a legal claim or security interest in certain assets or property that secures the payment of a financial obligation.

While each lender will have a lien on the same collateral, the first lien lenders will have higher relative priority to that collateral that the second lien lenders. The intercreditor agreement will establish the rights of each lender relative to the other lender with respect to priority to the collateral in the event that the company files for bankruptcy or defaults on its debt payment obligations. Two creditors can also have equal priority, also known as a pari passu interest, in the collateral.

An intercreditor agreement generally includes provisions covering the ranking of various debts, payment priority, lien subordination, information sharing, termination rights, governing law, and rights and remedies of the parties.

The concept of lien subordination refers to the second lien lenders agreeing that their interest in the lien on property is subordinate to that of the first lien lenders. The concept of payment subordination refers to the second lien lenders having to wait to receive payment of some or all of their claims until after the first lien lenders have been fully repaid. While lien subordination and payment subordination are distinct concepts, lien subordination often results in payment subordination.

Article 9 of the Uniform Commercial Code (UCC) governs the rights of secured parties to collateral across all 50 U.S. states. Under Article 9, the default rule is that a security interest is perfected by the first party to file a UCC-1 financing statement.

Common collateral can be subject to either the “absolute priority rule” or “relative priority rule” under the intercreditor agreement. If an intercreditor agreement follows the absolute priority rule approach, the first lien lender’s lien priority covers all assets defined as collateral under the security agreement. This is irrespective of whether the first lien lender has a valid and perfected lien over those assets.

If an intercreditor agreement follows the relative priority rule approach, the first and second lien lenders must both have valid and perfected liens over assets in order for them to be considered common collateral. If the second lien lender has enough negotiating power, it may be able to get the intercreditor agreement to reflect the relative priority rule approach. However, the absolute priority rule is the more commonly followed approach in intercreditor agreements.

The second lien lenders will typically negotiate a cap on the amount of proceeds of the collateral that may be paid out to the first lien lenders ahead of the second lien lenders receiving payments. This is known as a first lien debt cap. This cap amount generally applies only to the principal amount of the first lien debt and excludes interest expenses. The first lien lenders may negotiate some flexibility to add some additional amounts to the first lien debt amount at a future date while still preserving their lien priority rights.