Chasing Waterfalls: Priority, Enforcement, and Lender Protections

This is the second in a two-part series on waterfalls in syndicated and private credit. This Legal Update examines how the waterfalls distribute value among competing creditor classes and security structures, and highlight the primary legal risks to consider when structuring and negotiating deals. For an overview of how payments are applied within a single facility, see the first installment in this series, The ABCs of Credit Agreement Waterfalls.

Introduction

In this Legal Update, we look at how waterfalls allocate value in multicreditor structures, recent court decisions that affect priority protections, and key negotiation and drafting considerations for lenders. When multiple lender classes share a borrower, collateral package or credit structure, the waterfall begins allocating shared recoveries among groups whose interests may directly compete. In these situations, waterfall protections are among the most heavily negotiated—and potentially litigated—provisions in the deal. For lenders, whether in broadly syndicated facilities, private credit or fund finance, understanding how value is allocated among competing classes is essential to protecting priority.

Intercreditor Waterfalls

Intercreditor waterfalls determine how value is allocated among creditor constituencies that share a borrower, collateral package, or credit structure. These waterfalls most often appear in an intercreditor agreement (“ICA”). In contrast, unitranche facilities typically include the analogous allocation in an agreement among lenders (“AAL”). Unlike a borrower-level payment waterfall, which governs the application of payments within a single facility, an intercreditor waterfall allocates proceeds, payments or other recoveries across creditor classes.

The discussion below considers four recurring settings: (i) first-lien and second-lien lenders sharing the same collateral; (ii) ABL and term loan lenders holding alternative priority liens on separate collateral pools; (iii) first-out and last-out tranches within a unitranche facility; and (iv) other subordination arrangements, from mezzanine debt to guarantor recovery provisions.

First Lien vs. Second Lien: When first- and second-lien facilities share collateral, each credit agreement may have its own internal waterfall among lenders of that class, but the ICA sets priority between classes. The key feature is lien subordination: second-lien lenders hold junior liens on the shared collateral, so enforcement proceeds are applied first to the first-lien obligations—principal, interest, fees, and, where the ICA so provides, post-petition interest—before any collateral proceeds are distributed to the second-lien lenders.

Importantly, this is lien subordination, rather than payment subordination; second-lien lenders may retain their rights to scheduled interest and other ordinary-course payments before enforcement, subject to any applicable payment blockage or standstill provisions. Turnover provisions backstop that priority, so if a junior lienholder receives collateral proceeds out of turn, it must remit them to the senior creditor or collateral agent for redistribution. Because these priorities are fixed in the ICA, they are generally intended to be enforceable in bankruptcy under Section 510(a) of the Bankruptcy Code.

Split Collateral (ABL vs. Term Loan): In split-collateral structures, different lenders have first-priority liens on different pools of assets. A common example is an ABL revolver paired with a term loan. In this scenario, the ABL lenders may have first-priority liens on current assets, such as inventory, receivables and related cash proceeds. In contrast, the term lenders have first-priority liens on fixed assets, such as equipment, intellectual property and equity interests, with each creditor group holding a junior lien on the other’s priority collateral. The intercreditor waterfall is therefore collateral-specific. Proceeds of ABL priority collateral are applied first to the ABL facility, while proceeds of term priority collateral are applied first to the term loans. Any surplus may then be applied to the other creditor group if its claims remain unpaid. The documentation will specify each collateral category, the scope of proceeds, and any carve-outs or permitted liens.

Unitranche and First-Out/Last-Out Structures: In unitranche loans, which are increasingly common in private credit transactions, all lenders typically share one credit agreement and one lien, but the AAL reallocates economics and control rights between “first-out” and “last-out” tranches. The borrower generally pays a single blended rate under the credit agreement. The AAL then allocates those payments among the lenders: the first-out lenders receive a lower yield in exchange for their senior collateral position. In comparison, the last-out lenders receive a higher yield to compensate for their junior lien risk.

This ordinary-course allocation often applies until a defined triggering event, such as a payment default, insolvency event or acceleration. Upon that trigger, the AAL flips to an enforcement waterfall under which first-out lenders are paid first before last-out lenders receive any recovery. Negotiated points often include the cap on the first-out priority claim, whether default interest, unmatured interest or PIK interest is included, the last-out lenders’ right to purchase the first-out tranche at par plus accrued interest, voting allocations, enforcement control, standstill rights and turnover provisions.

Although the AAL may not be reflected in the borrower-facing credit agreement, it often determines a lender’s actual economic position in a unitranche facility. Bankruptcy enforceability is also important: first-out lenders often seek language stating that the AAL waterfall is a subordination agreement enforceable under Section 510(a) of the Bankruptcy Code and may seek waivers or limitations on last-out lenders’ bankruptcy rights to preserve the agreed-upon priority.

Other Subordination Arrangements: Waterfalls may also appear in mezzanine financings, second-lien/mezzanine structures, “second-out” tranches under a single credit agreement, guarantor recovery provisions and other bespoke arrangements. In each case, the core exercise is the same: identify every claimant that may share in collateral or payments, determine whether its priority applies in the ordinary course, after default, upon acceleration, or only upon enforcement, and confirm that the documents rank each claimant correctly in each scenario.

A first-lien lender will generally want to ensure that junior creditors cannot receive enforcement proceeds until the senior claims are paid in full. A second-lien or junior lender will want to confirm that it is entitled to recover once senior claims are satisfied, the composition and quantum of the senior claims and, where applicable, that it may continue receiving ordinary-course payments before enforcement.

Recent Developments

Beginning in 2020, uptier and priming transactions reshaped how the market approaches intercreditor waterfalls and the amendment provisions protecting them. Two points matter most: (i) how courts treat “open market purchase” exceptions used to rearrange priority, and (ii) the market’s move toward express “sacred rights” protecting pro rata sharing and waterfall priority.

The “open market purchase” exception: Posed with questions of whether a non-pro-rata debt exchange can fit within a credit agreement's “open market purchase” exception to ratable sharing, two appellate courts answered on the same day and reached opposite results. In Serta, the Fifth Circuit held that the 2020 uptier was not a permissible open-market purchase under the agreement’s pro rata sharing exception, reversing the bankruptcy court and leaving breach claims to proceed. In Mitel, the New York Appellate Division, First Department, reached the opposite result, upholding the transaction because Mitel’s agreement permitted loan acquisitions through any “purchase” allowed by its assignment provisions, without the “open market” qualifier that controlled Serta. These cases show that similar transactions may be sustained or struck down depending on the specific language in the pro rata sharing and sacred rights provisions.

The acceleration of “sacred rights”: In response to the “open market purchase” exception, the market has begun to expressly document “sacred rights” that lock down pro rata sharing, waterfall priority, and the lien and payment subordination provisions that support them. Recent case law does not establish a general rule that these protections will be implied when they are not stated expressly. Rather, at the motion-to-dismiss stage, courts have permitted excluded lenders to pursue claims based on related sacred rights and the credit agreement read as a whole. The outcomes nevertheless remain fact-specific.

In Boardriders, the court allowed excluded lenders’ breach-of-contract and implied-covenant claims to proceed, holding that an implicit sacred right may exist even in the absence of an express “no subordination” provision. In TriMark, the court read a consent right over “application of proceeds” to plausibly bar the majority from inserting a super-priority debt tranche above the plaintiffs in the waterfall, even though the distribution provision itself was unchanged. Together, these decisions provide excluded lenders with potential arguments when express antisubordination protections are absent, but neither provides a reliable substitute for clear contractual language.

As such, the best practice is to draft provisions that protect both the waterfall text and those provisions that feed, implement, or override it—including pro rata sharing, lien and payment subordination, application of proceeds, and the authority to enter into or amend intercreditor arrangements—and to require the applicable heightened consent for amendments that would directly or indirectly alter a lender’s priority.

Negotiation Pressure Points and Practice Considerations

Lenders should consider the following practical strategies for waterfall language to navigate common areas of contention:

• Fees, Expenses, Indemnities, and the Scope of “Obligations”: The defined “Obligations” (or “Secured Obligations”) should specify (i) top-bucket fees, enforcement costs and indemnities; (ii) included or excluded bank-product, affiliate and parent-company obligations; and (iii) treatment of contingent exposures, such as letters of credit or swap termination amounts, including any reserve or holdback.
• Hedge and Cash-Management Claims Rank: When hedges or treasury/cash-management obligations share the collateral, lenders should confirm they are pari passu in lien priority, but subordinated in payments and capped at a certain amount to prevent large termination payments from overwhelming loan recoveries.
• Default Interest and Post-Petition Interest: ICAs should state whether senior lenders recover default interest or post-petition interest before junior creditors receive payments. First- and second-lien ICAs often include post-petition interest in first-lien claims, whereas unitranche AALs may cap first-out priority by excluding default, post-petition or unmatured interest.
• Turnover and Setoff Clauses: Turnover and pro rata sharing clauses enforce the waterfall by requiring creditors to remit off-waterfall receipts for proper distribution. Setoff is the primary exception, with operational lenders seeking deposit access and the syndicate requiring ratable sharing. Other exceptions, including non-pro-rata buybacks, should be tightly limited.
• “Collateral Proceeds” Definition and Triggers: The ICA should define “proceeds” broadly enough to capture intended waterfall value, including plan recoveries, adequate-protection payments, insurance and condemnation proceeds, and other restructuring distributions, where appropriate.
• Intercreditor Agreement Review: In multi-lien structures, the ICA should match the term sheet and support the agreed priority with its enforcement control, payment priority, pro rata sharing, junior standstills, and bankruptcy provisions.
• Clarity on Post-Default Allocation: The documents should specify how payments are applied after default but before full enforcement, including whether the agent applies funds to accelerated debt and whether lenders can redirect application. Enforcement timing should not allow deviation from payment priorities.
• Defaulting Lender Provisions: Defaulting-lender provisions should redirect amounts otherwise payable to a non-funding or insolvent lender, including fees, participation shortfalls and letter-of-credit exposure, to protect the syndicate rather than leave value idle or return it to the borrower.
• Protect Against Amendments: Waterfall and pro rata sharing provisions should be protected as “sacred rights” requiring unanimous or all-affected-lender consent where appropriate.

Conclusion

Because waterfalls governs priority among lenders, and ambiguity often surfaces during workouts, precise drafting is crucial to protecting lender rights and minimizing the risk of disputes. Moreover, the waterfall’s tiers are only as safe as the provisions that protect them. Sharing clauses, standstill and bankruptcy provisions, and amendment protections can protect minority lenders. Accordingly, lenders’ protections and consent thresholds should be tailored to the specific lender group and collateral structure.