Intercreditor agreements between secured creditors are intended to limit the potential for litigation and result in predictable commercial outcomes with respect to recoveries from collateral in enforcement actions and bankruptcies. Despite the extensive drafting efforts of sophisticated counsel to eliminate ambiguities in these agreements, the interpretation of intercreditor agreements has been the subject of substantial bankruptcy litigation.
A key issue in every intercreditor agreement is whether it provides for payment subordination or only lien subordination. The difference between the two types of subordination is that payment subordination renders the junior debt subordinated in its right to recovery from all sources (whether collateral or not), whereas lien subordination renders the junior second lien debt subordinate in its right to receive payment from collateral (but otherwise would leave the debt pari passu with the first lien debt for non-collateral based recoveries). Although the outcome of intercreditor litigation necessarily is highly dependent on the language of the agreement at issue and the underlying facts of the case, a recent Delaware Bankruptcy Court decision in the chapter 11 case of La Paloma Generating Co. is of interest because the Bankruptcy Court suggested that payment subordination was intended by the parties despite the lack of any express payment subordination provision in the document.
As discussed in greater detail below, the La Paloma case presented a somewhat complex fact pattern involving whether recoveries to the second lien debt that were made available to all unsecured creditors (including what otherwise would have been the deficiency claim of the second lien creditors) as a result of the fact that the first lien debt had not properly perfected its security interest were subject to the turnover provisions of the intercreditor agreement. Although the decision could have turned, and seemingly did turn, solely on whether the proceeds of improperly perfected “collateral” were subject to the turnover and waterfall provisions of the intercreditor agreement, the court took a seemingly unnecessary turn and expressed its view, without any real support, that the intercreditor agreement in question provided for claim subordination. The junior creditors have appealed the decision.
La Paloma Generating Company, LLC and certain of its affiliates (collectively, the “Debtors”) commenced voluntary chapter 11 cases before the United States Bankruptcy Court for the District of Delaware in December 2016. The Debtors’ prepetition capital structure included first lien and second lien facilities that were subject to an intercreditor agreement and secured by substantially all of the Debtors’ assets.
The Debtors filed a plan of reorganization in September 2018 that incorporated a settlement of a number of disputes with the first lien creditor, including disputes arising out of the fact that the UCC financing statement filed by the collateral agent had lapsed prepetition. Specifically, the plan provided that the first lien lenders would, among other things, credit bid for substantially all of the Debtors’ assets and forgo the benefit of their liens on certain assets for the benefit of unsecured creditors. The plan then provided that distributions that otherwise would have gone to the second lien lenders on account of their unsecured claims would be held in reserve with the collateral agent, pending a determination by the Bankruptcy Court as to whether the second lien lenders were entitled to such amount in light of the turnover and related provisions of the intercreditor agreement. The first lien and second lien lenders subsequently brought dueling motions before the Bankruptcy Court seeking to enforce the intercreditor agreement.
The Bankruptcy Court granted the first lien lenders’ motion to enforce the intercreditor agreement largely focusing its analysis on the “turnover” provision of the intercreditor agreement. The turnover provision requires that second lien creditors turn over to the Collateral Agent, any collateral or the proceeds of collateral that they receive prior to the payment in full of the first lien creditors. The court concluded that the first lien lenders needed to show that four elements were satisfied in order to trigger a payment turnover by the second lien lenders: (i) the distribution must be collateral or proceeds thereof; (ii) the distribution must be received in connection with the exercise of any right or remedy by the second lien creditors; (iii) any such exercise of a right or remedy must relate to the collateral; and (iv) the exercise of such right or remedy must be in contravention of the intercreditor agreement. The Bankruptcy Court analyzed each of the four elements in turn and then examined the “waterfall” provision of the intercreditor agreement.
Collateral or Proceeds Thereof
The definition of “collateral” in the intercreditor agreement included all property “…intend[ed] to constitute” collateral for the first lien or second lien obligations. Moreover, the intercreditor agreement contained the standard savings provision that the priority of the first lien creditor over the second lien creditor would not be affected by any issue concerning the perfection or avoidability of liens securing the first lien obligations or any defects or deficiencies in, or failure to perfect, such liens. The first lien lenders contended that substantially all of the Debtors’ assets were subject to the lapsed lien, and, therefore, when the assets were sold pursuant to the plan of reorganization, the proceeds of the sale were proceeds of collateral. Although the second lien creditors asserted that there were unencumbered assets, which presumably would have fallen outside of the definition of collateral, the Bankruptcy Court rejected that assertion as being without evidentiary support, and concluded that under the facts before it, and the broad definition of “collateral,” such distributions were “collateral or proceeds thereof.”
Exercise of Remedies
The Bankruptcy Court concluded that this factor had been satisfied by the filing of a proof of claim in the bankruptcy case by the second lien agent. In reaching that conclusion, the Bankruptcy Court distinguished its own decisions in Energy Future Holdings, on the basis that the definition of “exercise of remedies” in the intercreditor agreement in that case did not include the filing of a proof of claim. The Court found that the intercreditor agreement at issue, in which the filing of a proof of claim was one of the limited exceptions to the prohibited exercise of remedies, made such filing an explicit exercise of a remedy.
Exercise of Remedies Must Relate to the Collateral
The Bankruptcy Court concluded that this factor was easy. Given the Bankruptcy Court’s determination that the filing of a proof of claim was an exercise of remedies and “collateral” includes all distributions under the plan of reorganization, the Bankruptcy Court found that this element was met.
Contravention of Intercreditor Agreement
The Bankruptcy Court found the fourth element satisfied in the event the second lien creditors, prior to the satisfaction in full of the first lien obligations, received distributions as a result of their exercise of remedies (i.e., filing the proof of claim).
Application of Waterfall
With the Bankruptcy Court having reached the conclusion that the distributions under the Plan were the proceeds of collateral, it could easily have concluded that the distribution of those proceeds would have been subject to the intercreditor agreements waterfall—which provided for the Collateral Agent to make distributions first to the first lien lenders. Rather than simply ending the analysis there, the Bankruptcy Court took a curious turn into whether the intercreditor agreement provided for payment subordination, and, without real support other than the waterfall itself, concluded that based upon the totality of the “intercreditor agreement,” the parties intended for there to be payment subordination. The detour taken by the Bankruptcy Court was unnecessary because, having found that the distributions in question were the proceeds of collateral, whether payment subordination was contemplated simply was not relevant.
As would be expected, the second lien lenders appealed the Bankruptcy Court’s decision to the United States District Court for the District of Delaware. The issues on appeal are whether the four elements required for a payment turnover were met and whether an explicit lien subordination intercreditor agreement implicitly provided for payment subordination. The breadth of the Bankruptcy Court’s interpretation of the subordination provisions of the intercreditor agreement is concerning from a junior creditor perspective and if the decision is upheld on appeal it will provide a basis for senior creditors to argue for payment subordination even in the absence of an express payment subordination provision.
Although it is possible that the Bankruptcy Court misconstrued the facts and the applicability of the specific terms of the intercreditor agreement when it waded into its view on whether claim subordination was intended, the language of the decision could prove beneficial to first lien creditors (and detrimental to second lien creditors) in future disputes where recoveries are derived from intentionally unencumbered assets. The impact will be more significant if the reasoning in the decision is upheld on appeal.