While investors and lenders brace for the next wave of chapter 11 filings, those who are parties to intercreditor agreements need to take stock on how their relationship with their fellow creditors and the borrower may be impacted by a bankruptcy filing by the borrower. If the borrower is in financial extremes, the primary lender who is secured by all the business assets may be unwilling or unable to extend additional credit to the troubled borrower. Indeed, the sour credit may already have been modified and maturity extended under a workout or forbearance agreement, only to result in the borrower still being unable to pay the indebtedness at the extended maturity date.
Enter a new lender willing to provide additional working capital to the troubled company. This new lender or investor may only be willing to extend additional capital if the existing first lender will agree to the subordination of its debt and lien position to that of the new lender or investor. This new source of working capital may also seek to extract additional concessions from the subordinating lender concerning its relative rights against the borrower in the event of a bankruptcy filing.
The parties typically enter into an intercreditor agreement to establish their respective rights between themselves and in relation to the borrower. Intercreditor agreements often require the subordinating creditor to assign and subordinate all of its claims and rights against the borrower and the collateral until the new lender or investor is paid in full. In addition to the subordination of the senior indebtedness and lien position, these intercreditor agreements frequently contain more exacting provisions that affect the rights of the creditors in the event of a bankruptcy filing by the primary obligor. These agreements typically include the waiver of any rights to object to any post-petition, debtor-in-possession (DIP) financing that the new lender may seek to extend to the chapter 11 debtor, the waiver of any right of the subordinated lender to object to the chapter 11 debtor's use of its cash collateral and to demand adequate protection of its lien position as provided for under the Bankruptcy Code, the right to object to any bankruptcy court-ordered sale of assets (so-called "363 sales"), the right to assert and file a proof of claim on behalf of the subordinated lender, and perhaps most onerous, the waiver of the right of the subordinated lender to vote on any plan of reorganization that the chapter 11 debtor may propose and seek to confirm, to include the assignment of that voting right to the new lender or investor.
Bankruptcy Code provisions on statutory priority and rights of holders of claims in bankruptcy will conflict with intercreditor agreements that seek to alter payment priorities or other rights under the Bankruptcy Code. Generally, bankruptcy courts will enforce subordination provisions related to payment and priority of liens contained in intercreditor agreements, but enforcement of the waivers and assignments of bankruptcy rights that do not relate to payment or priority of liens may not be universally upheld.
A leading case on the enforceability of these subordination and bankruptcy waiver provisions in intercreditor agreements upheld the bare subordination of the indebtedness and the lien priorities, but found the waivers of the subordinating creditors' non-monetary rights under the Bankruptcy Code unenforceable. However, a December 2006 decision has upheld these waivers. The differences between these two holdings highlight the two views on the enforceability of these provisions in the context of a chapter 11 filing. By examining these decisions, certain insights on how to craft intercreditor agreements so that they can be enforced within the content of a chapter 11 filing can be ascertained.
In 2000, the Bankruptcy Court for the Northern District of Illinois held in the case of 203 N. LaSalle Street Partnership that the provisions of an intercreditor agreement that sought to transfer certain chapter 11 plan voting rights of a junior creditor to the senior lender were unenforceable. The LaSalle court ruled on the issue of the extent and scope of the junior lien holder's subordination of its unsecured claim. The LaSalle court declined to enforce the waiver of the right to vote for confirmation of the proposed plan, concluding that the subordination of the debt and the lien position pursuant to the terms of the intercreditor agreement were enforceable, but that the assignment of the right to vote on the proposed plan was not. The bankruptcy court in the LaSalle case refused to permit parties to use contractual provisions to alter the intent of Congress as set forth in the Bankruptcy Code and modify the provisions of the Bankruptcy Code, ruling that the "fact that the [subordinating creditor] agreed that the Bank could vote its claim does not provide a basis for disregarding [the Bankruptcy Code]," and going further in its opinion by stating "[w]hile the language of the subordination agreement governs the outcome of the Bank's right to payment of any . . . claim, the language of the Bankruptcy Code governs the determination of voting rights." The LaSalle court also noted that there was a growing body of law holding pre-petition contracts that waive substantive bankruptcy rights to be unenforceable, stating that "it would defeat the purpose of the [Bankruptcy] Code to allow parties to provide by contract that the provisions of the Code should not apply."
Other bankruptcy courts have upheld the provisions contained in intercreditor agreements waiving and assigning the rights of the subordinating creditors.
In December of last year, the Bankruptcy Court for the Northern District of Georgia held in the case of Aerosol Packaging LLC that the terms of an intercreditor agreement between Wachovia Bank and an investment fund could be fully enforced, finding that the Bankruptcy Code provisions addressing the right of a "holder" to vote a "claim" were silent on the issue of whether that right could be delegated under a contract entered into before the chapter 11 filing.
The Aerosol Packaging court also found that the Bankruptcy Code provision that recognized the enforceability of subordination provisions if enforceable under applicable non-bankruptcy law made specific reference to subordination agreements, but chose not to distinguish between the payment and lien priority aspects and waivers of non-monetary bankruptcy rights contained in the intercreditor agreement. As stated by the Aerosol Packaging court, 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."
Lenders and investors entering into intercreditor agreements that contain these subordination and bankruptcy rights waiver provisions can bolster the likelihood that a bankruptcy court will uphold them by careful drafting. Parties to the intercreditor agreement need to be as specific and detailed as possible in the contract concerning their relative rights, because clear language as to exactly what interests (both monetary and non-monetary) are being subordinated is critical to the validity of these agreements when scrutinized by a bankruptcy court. The intercreditor agreement must specifically subordinate all of the payment claims of the prior lender (whether arising pre- or post-petition, under any of the loan documents, or by virtue of the Bankruptcy Code) to all the claims and rights of the new lender or investor, and delineate, by specific category, the other rights being affected. Specific and unequivocal language that supports the agreement that the subordinating lender must stand by and allow the new, senior lender or investor to be paid in full before the subordinating lender receives any payment or exercises any rights in the bankruptcy case must be set forth in the intercreditor agreement. The waivers set forth in the intercreditor agreement should include a detailed listing of all of the rights being subordinated, waived, and assigned.
An intercreditor agreement that has been drafted with clarity and precision and, perhaps more importantly, in anticipation of a later challenge in the bankruptcy court will result in an increased possibility that the provisions of these agreements will be upheld if attacked in a bankruptcy proceeding.