As we began discussing this week in our previous entries, on August 26, 2014, Judge Drain of the Bankruptcy Court for the Southern District of New York issued a momentous bench ruling in connection with the confirmation hearing of Momentive Performance Materials and its affiliates. The decision grappled with a number of important topics in modern, complex chapter 11 bankruptcies. In Parts I and II of this series, we examined Judge Drain’s analysis of secured party cramdown considerations in detail. In this entry, we turn to the topic of subordination. In Part IV, we will explore both the “make-whole” aspects of Judge Drain’s decision and third party releases.

What You Need to Know: Subordination

As a preliminary matter, section 510(a) of the Bankruptcy Code serves as the basis for most subordination discussions in bankruptcy court — just as it did in Momentive. The provision simply enforces subordination agreements to the same extent they would be enforceable under nonbankruptcy law.

On its face, section 510(a) appears to be aimed primarily at creditors, as subordination provisions are frequently found in intercreditor agreements or in entirely separate subordination agreements — documents to which the debtor may not even be a party. As Judge Drain noted in his ruling, though, the application of section 510(a) has a profound effect on debtors and their chapter 11 plans. Confirmation of a plan necessitates meeting the various requirements of section 1129, including section 1129(a)(1), a catch-all requiring a plan to comply with “the applicable provisions of this title.” In short, even though a subordination fight appears at first blush to be a squabble solely among creditors, proper prioritization of debt in a plan requires the plan proponent to sort these subordination issues out.

The Subordination Provision in Momentive

Yesterday’s entry generally described the classes and their proposed treatment under the plan and focused on the objections raised by the two most senior classes in the plan – the first lien notes and the 1.5 lien notes. The subordination fight in Momentive pitted two other classes of creditors against each other – the unsecured senior subordinated notes (“Senior Sub Notes”) and the second-priority springing lien notes (“Second Lien Notes”). Momentive’s plan proposed to give the Second Lien Notes a recovery of approximately 12.8% to 28%, but wiped out the Senior Sub Notes on the ground that the Senior Sub Notes were subordinated to the Second Lien Notes.

Not long after the chapter 11 filing, the Senior Sub Notes filed an adversary proceeding against the Debtors and the Second Lien Notes seeking a declaration that the Senior Sub Notes were not subordinated to the Second Lien Notes. Although the Second Lien Notes would have a senior right to any recovery on account of their liens (which were wholly underwater, and therefore, valueless), the Senior Sub Notes argued that, pursuant to the terms of the applicable indenture, any unsecured claims of the two classes should be pari passu.

As these disputes go, resolution depended upon an interpretation of the subordination provision in the indenture governing the Senior Sub Notes. That indenture, governed by New York law, provided that the Senior Sub Notes would be subordinated to “all existing and future Senior Indebtedness of the Company” and added that “only Indebtedness of the Company that is Senior Indebtedness of the Company shall rank senior to the [Senior Sub Notes] . . . .

The adversary proceeding thus hinged on the definition of “Senior Indebtedness in the indenture for the Senior Sub Notes. The Senior Sub Notes indenture defined “Senior Indebtedness” as follows:

all Indebtedness . . . unless the instrument creating or evidencing the same amount or pursuant to which the same is outstanding expressly provides that such obligations are subordinated in right of payment to any other Indebtedness of the Company or such Restricted Subsidiary, as applicable; [we will call this the “Payment Subordination Provision”] provided however, that Senior Indebtedness shall not include, as applicable:

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(4) any Indebtedness or obligation of the Company or any Restricted Subsidiary that by its terms is subordinate or junior in any respect to any other Indebtedness or obligation of the Company or such Restricted Subsidiary, as applicable, including any Pari Passu Indebtedness [we will call this the “Subordination Exception”] . . . .

The crux of the adversary proceeding turned on the meaning of “junior in any respect.” The holders of the Senior Sub Notes argued that, because the liens securing the Second Lien Notes were junior in priority to those of the first lien notes and the 1.5 lien notes, the Second Lien Notes were “junior in any respect to … other Indebtedness,” and, therefore, fell within the language of the Subordination Exception. The result of that would be that the Senior Sub Notes and the Second Lien Notes would be pari passu with respect to the unsecured claims of the Second Lien Notes. In a bit of unhelpful contractual circularity, the indenture for the Second Lien Notes (an agreement to which the holders of the Senior Sub Notes were not parties) provided that the Second Lien Notes were senior to any “Subordinated Indebtedness.”

Court Holds That New York Law on Contract Interpretation Dictates That the Second Lien Notes Were Not Subordinated

Because the Bankruptcy Code provides that subordination agreements are only enforceable in bankruptcy to the extent they are enforceable under applicable nonbankruptcy law, Judge Drain began his decision with a primer on contract interpretation under New York law. These “well established” fundamental principles included the following concepts:

According to the court, these guiding principles of contract interpretation led to only one conclusion — the Subordination Exception was not intended to affect the Second Lien Notes’ senior right to payment with respect to the Senior Sub Notes.

Looking first at the principle that the contract should be construed to give effect to all its provisions, Judge Drain noted that the Senior Sub Noteholders’ interpretation of the Subordination Exception would “swallow up” the Payment Subordination ProvisionThe court instead sided with Momentive’s interpretation of the Subordination Exception, which it concluded gave meaning to the Subordination Exception only in situations where a separate subordination agreement, rather than the instrument itself, caused the subordination.

The court also held that Momentive’s interpretation tracked the plain terms of the Subordination Exception. The Subordination Exception, read strictly, said that Senior Indebtedness would not include Indebtedness “that by its terms is subordinate or junior” to any other Indebtedness. The indenture for the Second Lien Notes, which created the “Indebtedness,” did not by its terms subordinate the Second Lien Notes to any other debt. On the contrary, only the lien securing the Second Lien Notes was subordinated as a matter of lien priority to another lien. As Judge Drain reasoned, “liens secure debt and are not themselves debt,” and thus they fall outside of the meaning of “Indebtedness.

As a final theory, the Senior Sub Noteholders argued that, under Momentive’s interpretation of the Senior Sub Notes indenture, the debtors could theoretically continue to add priority notes ahead of the Senior Sub Notes by providing the new debt with illusory undersecured (in whole or in part) liens. Considering this possibility, the Senior Sub Noteholders argued that the Subordination Exception served an important “anti-layering” function.

The court, however, refused to buy the argument. Looking to the indenture for the Senior Sub Notes for context, Judge Drain pointed out that the indenture had no anti-layering provision or covenant, even though it contained plenty of other provisions about incurring additional debt. Instead, the court pointed to the Senior Sub Noteholders’ own evidence to support the argument that, “if one wants to exclude debt secured by a junior lien from the benefit of a subordination provision, [one should] do so in an anti-layering covenant.”

Conclusion

Decisions interpreting subordination agreements often serve as a reminder of the importance of using precise language, particularly when it comes to defining the relative rights of creditors in different agreements. Momentive is no exception. Although Judge Drain may have characterized his reading of the contractual provisions as having been based upon the “plain meaning” of the Payment Subordination Provision and the Subordination Exception, potential ambiguity created by four words in a lengthy document – “junior in any respect” – opened the door to litigation.