On January 13, 2020, the United States Bankruptcy Court for the District of Delaware issued an opinion in In re La Paloma Generating Company, LLC., Case No. 16-12700 [Adv. Pro. No.19-50110], which examined the implied covenant of good faith and fair dealing in the context of an intercreditor agreement (“ICA“) governing the relationship between the First Lien Lender and the Second Lien Lenders to the Debtors. The bankruptcy court held a party cannot be in breach of the covenant of good faith and fair dealing under New York law when merely exercising a contractual right. In this case, the First Lien Lender was exercising a contractual entitlement under the ICA to enforce its right against the collateral of the Debtors.

Background

The First Lien Lender and Second Lien Lenders (together, “Lenders“) provided prepetition financing to the Debtors for the purchase and operation of an electricity generating plant. The parties entered into the ICA, which stipulated that the First Lien Lender held a first-priority security interest in substantially all of the Debtors’ assets and the Second Lien Lenders held a junior interest in the same assets.

Upon the Debtors’ filing for chapter 11, it was understood by all parties that there would be insufficient assets to satisfy the First Lien Lender’s first-priority lien in full.

The collateral agent for the Lenders failed to file a financing statement in respect of the Debtors’ property, leaving the security interest potentially avoidable. The Debtors and the First Lien Lender subsequently settled (“Settlement“) with respect to the financing statement, and the Settlement was incorporated into the Debtor’s Plan of Reorganization. Notably, the Settlement set aside a portion of funds to which the Second Lien Lenders could potentially be entitled (“Disputed Funds“), subject to pending results of a further hearing on competing motions to enforce the ICA. The bankruptcy court subsequently held that the ICA was unambiguous and the First Lien Lender was entitled to receive all of the Disputed Funds, a decision which was affirmed by the district court. Our previous Weil Blog article analyzed the initial opinion of the bankruptcy court and its implications, which can be accessed here.

In February 2019, the First Lien Lender filed an initial complaint to enforce further the terms of the ICA against the Second Lien Lenders. The Second Lien Lenders asserted a counterclaim for breach of the covenant of good faith and fair dealing as to the First Lien Lender’s actions during the bankruptcy proceedings. The First Lien Lenders moved to dismiss the counterclaim.

Under New York law, every contract has an implied covenant of good faith and fair dealing that prohibits parties to the contract from engaging in conduct intended to deprive the other party from receiving the benefits of the contract.

In this case, the Second Lien Lenders argued that the First Lien Lender breached the covenant of good faith and fair dealing by:

  • refusing to include the Second Lien Lenders in negotiations between the First Lien Lender and the Debtors in relation to potentially avoidable liens;
  • intentionally impeding the Second Lien Lenders’ rights as unsecured creditors; and
  • “using its status” as the senior secured lender to coerce the Debtors into agreeing to the Settlement, which was designed to trample on the Second Lien Lenders’ rights under the ICA.

Outcome

The bankruptcy court granted the First Lien Lender’s motion to dismiss the Second Lien Lenders’ counterclaim.

The opinion noted the ICA specifically allowed the First Lien Lender to “enforce rights, exercise remedies… and make determinations regarding the release, disposition, or restrictions with respect to the Collateral without any consultation with or consent of the [Second Lien Lenders]…all in such order and in such manner as they may determine in the exercise of their sole discretion.” As noted, the bankruptcy court had already ruled in favor of the First Lien Lender in granting its motion to enforce the ICA.

As such, the First Lien Lender was entitled to proceed against the collateral of the Debtors however it sees fit, which included the incorporation of the Settlement. Because the First Lien Lender was merely enforcing its contractual right under the ICA, it could not be in breach of the covenant of good faith and fair dealing by doing so.

The bankruptcy court further noted that the Second Lien Lenders could not be deprived of a right to which they were not entitled, as pursuant to the terms of the ICA, the Second Lien Lender would have to pay any recovered funds against the collateral to the First Lien Lender, until the First Lien Lender’s obligation was satisfied in full.

Takeaways

Senior creditors with intercreditor agreements with junior creditors can take solace from this opinion that merely enforcing their contractual rights in respect of debtor’s collateral will not breach the covenant of good faith and fair dealing.

Conversely, this opinion shows a party will not have the ability to rely on the covenant of good faith and fair dealing if the counterparty has simply undertaken actions in accordance with its rights and/or privileges under a contract.

It is important for senior creditors when negotiating intercreditor agreements, that clauses regarding their rights and priorities in relation to collateral of the debtor are clearly and unequivocally stipulated. This will ensure future dealings and negotiations between the senior creditor and debtor will not concern a breach of the covenant of good faith and fair dealing, as the senior creditor will be simply relying on its rights, priorities and/or entitlements under the intercreditor agreement.