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Intercreditor/Subordination Agreements in the Second Lien Generation
July 20, 2007
With the virtual explosion of second lien financings in recent years, the next wave of major bankruptcies will present numerous issues regarding the enforceability of various aspects of intercreditor agreements between first lien and second lien lenders. While lien subordination and payment subordination are clearly enforceable under § 510(a) of the Bankruptcy Code, there is uncertainty regarding the enforceability of provisions in intercreditor agreements that affect fundamental bankruptcy rights.
Many intercreditor agreements purport to transfer or limit the junior creditor's exercise of fundamental bankruptcy rights, such as the right to vote and/or prosecute a claim. In the second lien context, intercreditor agreements often, in anticipation of post-petition financing issues, seek to limit or eliminate the second lien lender's right to seek adequate protection and/or object to cash collateral use and any DIP financing provided by (or consented to by) the first lien lender. Some intercreditor agreements also seek to waive the second lien lender's statutory right to seek payment in cash of administrative claims that it obtains in bankruptcy, forcing such lenders to accept securities or other consideration instead.
The law on the enforceability of intercreditor agreement provisions that go beyond mere lien/payment subordination is unclear. Some courts have held that an intercreditor agreement cannot waive fundamental bankruptcy rights of a second lien lender and further that § 510(a) of the Bankruptcy Code was not intended to allow the enforcement of provisions of a subordination agreement that extend beyond subordination of rights to the distribution of estate assets. See e.g., In re Hinderliter Indus., Inc., 228 B.R. 848, 850 (Bankr. E.D. Tex. 1999) ('"The intent of § 510(a) (subordination) is to allow the consensual and contractual priority of payment to be maintained between creditors among themselves in a bankruptcy proceeding. There is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets."') (citation omitted); Beatrice Foods Co. v. Hart Ski Mfg. Co.(In re Hart Ski Mfg. Co., Inc.), 5 B.R. 734, 736 (Bankr. D. Minn. 1980) (holding intercreditor agreement provisions limiting adequate protection rights not enforceable under § 510(a)); Bank of America, Nat'l Ass'n v. North LaSalle St. Ltd. P'ship (In re 203 N. LaSalle St. P'ship), 246 B.R. 325, 331 (Bankr. N.D. Ill. 2000) (holding that subordination agreement could not affect bankruptcy voting rights).
However, other courts have interpreted § 510(a) more broadly to enforce certain pre-bankruptcy agreements that limit or waive a junior lender's statutory bankruptcy rights if the agreement is enforceable as a matter of applicable non-bankruptcy law (usually relevant state contract law). See In re Curtis Center Ltd. P'ship, 192 B.R. 648, 660 (Bankr. E.D. Pa. 1996) (enforcing subordination agreement provision assigning junior creditor's bankruptcy voting right to senior creditor); In re Inter Urban Broad. of Cincinnati, Inc., No. 94-2382, 1994 U.S. Dist. LEXIS 16546, at *6-7 (E.D. La. 1994) (same); cf. In re Itemlab, Inc., 197 F.Supp. 194, 197-98 (E.D.N.Y. 1961) (holding that junior creditor "equitably assigned" right to vote claim to senior creditor where senior creditor would not recover full amount of its claim).
Recently, the Bankruptcy Court for the Northern District of Georgia joined this line of cases by upholding a senior creditor's right to vote a junior creditor's claim pursuant to a prepetition subordination agreement in Blue Ridge Investors, II, LP v. Wachovia Bank, N.A. (In re Aerosol Packaging, LLC), 362 B.R. 43 (Bankr. N.D. Ga. 2006). In this case, the junior lender entered into a subordination agreement that subordinated in all respects the junior lender's claims and liens against the debtor to the claims and liens held by the senior lender. The subordination agreement contained broad language that authorized the senior lender to take certain actions in the junior lender's name. The bankruptcy court interpreted this language as authorizing the senior lender to (i) vote the junior lender's claims in any future bankruptcy proceeding of the debtor, and (ii) demand, sue, collect or receive any distribution of the debtor's assets distributed to the junior lender until such time as the senior lender's claims were paid in full.
Both the junior lender and the senior lender voted the junior lender's claim in the debtor's subsequent bankruptcy. The junior lender maintained that the subordination agreement was not enforceable, as a matter of bankruptcy law, since it impaired the junior lender's statutory bankruptcy voting rights.
The bankruptcy court interpreted § 510(a) broadly as permitting the enforcement of subordination agreements in bankruptcy so long as such agreements are enforceable under applicable nonbankruptcy law. Since the subordination agreement appeared to be enforceable under Georgia law, the court allowed the senior lender to vote the junior lender's claims under Federal Rules of Bankruptcy Procedure 3018 and 9010, which authorize agents and other representatives to take actions, including voting, on behalf of parties. In addition, the court determined that § 1126 of the Bankruptcy Code "grants a right to vote to a holder of a claim, but does not expressly or implicitly prevent that right from being delegated or bargained away by such holder." The court also noted that the junior creditor was not without a remedy since it could "free itself from the ongoing effect of the Subordination Agreement by paying the senior lender's claim in full in cash.''
The Aerosol Packaging decision is likely a precursor of many decisions to come regarding the enforceability of intercreditor agreements that have been entered into in connection with the recent second lien financing trend. It indicates that some courts will broadly enforce provisions of an intercreditor agreement that go beyond traditional lien/payment subordination and affect significant statutory rights that only arise as a result of a bankruptcy filing. These courts strictly enforce the contractual bargain between the parties in the intercreditor agreement. However, other courts have and likely will continue to adopt narrower constructions of § 510(a) and refuse to enforce intercreditor provisions that impair significant bankruptcy rights. The lack of clarity in the law on these issues will continue until these issues are presented to courts in the more popular bankruptcy venues (e.g., New York, Delaware and Texas) and decided by higher courts on appeal.
This should not take long during the next wave of major restructurings. The prevalence of these issues in second lien financings make these issues "first day" matters that will need to be consensually resolved or decided by the bankruptcy court. Almost every DIP financing or cash collateral proposal will trigger issues embedded in intercreditor agreements relating to second lien lender rights to seek adequate protection or object to post-petition financing arrangements. Disputes under intercreditor agreements can be postponed (and avoided) through consensual resolutions, as occurred in the Dura Automotive case where the parties agreed to provide the second lien lenders (represented by Bracewell) with adequate protection treatment in the form of current cash payment of interest during the bankruptcy case, which the intercreditor agreement, if enforceable, did not permit. In other cases, economics and other dynamics will require judicial resolution. Investors and lenders should consider the risks associated with this grey area of the law relating to intercreditor agreements as part of their decision to invest in a first lien/second lien financing structure.