Recently, several courts have added to the growing body of decisions construing intercreditor agreements in bankruptcy cases. As a general rule, an intercreditor agreement, like any other contract, must be enforced according to the plain meaning of its terms.1 Various exceptions have developed in the case law, and one that bankruptcy courts have applied to intercreditor agreements is the "bankruptcy imperative." Essentially, this is a public policy doctrine, cited to excuse a creditor’s prepetition contractual waiver if it relinquishes a core right under the Bankruptcy Code,2 such as the right to vote on a plan of reorganization or, in some cases, the right to be heard as a creditor. The precise contours of this doctrine are difficult to define, but these recent cases show a trend towards narrowly construing the exception, more so when a right is explicitly and expressly waived.
Ion Media was the first in a series of bankruptcy court decisions since the recent financial crisis to rule on the enforceability of prepetition intercreditor agreements among lenders, and to a certain extent set the stage for decisions going forward.3
The intercreditor agreement contained an acknowledgment that the first lien lenders’ interest in the collateral was senior to the second lien lenders’ interest and an acknowledgement that the priority scheme would not be impaired by, among other things, the nonperfection of a lien purportedly securing the obligations.4 The acknowledgment of priority notwithstanding the perfection or nonperfection of the liens "purportedly securing" the obligations was significant in light of Ion Media’s FCC broadcast licenses because although the security agreement purported to grant the lenders a lien on the licenses, applicable law limited the extent to which a security interest in such a license may be granted.5 The intercreditor agreement also provided that upon commencement of a case under the Bankruptcy Code, the second lien lenders agreed not to contest "the validity, priority, or enforceability of the Liens, mortgages, assignments, and security interests granted pursuant to the Security Documents[.]"6
Viewing the legal limitations regarding the licenses as a potential hole in the first lien lenders’ collateral package, an investor had purchased deeply discounted second lien debt and contended that it should share, pari passu, the value of the FCC licenses with the first lien lenders and any other creditors of the entities holding the licenses. The bankruptcy court overruled the second lien lender’s objections to the plan and held that the lender lacked standing to challenge either the validity of the first lien lenders’ security interests or the priority of the first lien lenders’ claims. The holding was based on the premise that the second lien lenders provided loans to Ion Media with full knowledge that the liens on the FCC licenses were arguably invalid. As the court put it, "[a]t bottom, the language of the Intercreditor Agreement demonstrates that the Second Lien Lenders agreed to be ‘silent’ as to any dispute regarding the validity of liens granted by the Debtors in favor of the First Lien Lenders and conclusively accepted their relative priorities regardless of whether a lien ever was properly granted in the FCC Licenses."7 That the lien on FCC licenses might have been invalid was not relevant to the relationship between the first and second lien lenders — the intercreditor agreement constituted an enforceable contractual waiver of the right to challenge the validity of the first lien lenders’ liens and the priority scheme with respect to purported collateral.
In re Centaur, LLC
Following Ion Media, three general considerations have cut across many of the decisions addressing the enforceability of intercreditor agreements: (i) whether the agreement expressly and specifically addressed the action that the senior creditor sought to prevent, (ii) whether the junior creditor action implicated the "bankruptcy imperative" and fundamental bankruptcy rights and (iii) whether the court viewed the subordinated party as obstructionist. The most recent ruling of import is the Centaur8 decision, where the rule in Ion Media was effectively broadened by the posture of the case at the time of the court’s decision and the strict enforcement of the waivers in the intercreditor agreement.
In October 2009, Centaur affiliates Centaur PA Land, LP and Valley View Downs, LP, filed chapter 11 petitions in Delaware, and in March 2010, Centaur and 12 additional affiliates filed chapter 11 petitions in the same court. As of October 2009, Centaur owed more than $380 million in first lien debt and $180 million in second lien debt. At the first day hearing, a second lien lender objected to the debtors’ motion to approve the proposed cash collateral order on the basis that adequate protection liens should not extend to the assets of a particular debtor (the Valley View Debtor). The second lien lender asserted that the assets of this debtor were substantially unencumbered and should be available for unsecured creditors. The first lien agent raised, among other arguments, various contractual waivers in the intercreditor agreement; however, the duty judge covering the first day hearing declined to hear argument on intercreditor issues.
At the final cash collateral hearing, the second lien agent objected to the proposed cash collateral order on substantially the same basis asserted by the second lien lender at the first day hearing. The second lien agent also attempted to question the debtors’ witness in support of the cash collateral motion on the propriety of the adequate protection package. The first lien agent interjected and asserted that such questioning would be in derogation of the intercreditor agreement, which barred the second lien agent from opposing the entry of a cash collateral order acceptable to the first lien agent. The second lien agent countered that the intercreditor agreement permitted it to make arguments related to matters that would impact the debtors’ plan of reorganization and viewed the breadth of the proposed adequate protection as such a matter. The bankruptcy court found that the specific terms of the intercreditor agreement barred the second lien agent from pursuing its objection and noted that while there may be certain circumstances where provisions of an intercreditor agreement should not be enforceable "because the bankruptcy imperative involved may be more important," that was not the circumstance here where the intercreditor agreement did not restrict the first lien lenders in making a request for adequate protection and where the requested adequate protection was consistent with the intercreditor agreement.9
Notwithstanding the court’s position at the final cash collateral hearing with respect to the enforceability of the intercreditor agreement, the second lien agent continued to take positions that challenged the validity and extent of the first lien agent’s liens. The first lien agent consistently asserted in its responsive pleadings that the second lien agent’s challenges violated the intercreditor agreement.10 While the parties debated the issue in various pleadings throughout the cases, the issue did not come to a head until plan confirmation discovery.
The debtors proposed a plan that incorporated a settlement among the debtors, the first lien agent and the unsecured creditors’ committee, which would resolve various alleged estate claims brought by the creditors’ committee (including a claim challenging the first lien agent’s lien on the Valley View Debtor’s assets). In connection with its planned objection to the settlement and plan, the second lien agent served broad discovery requests which focused on the validity of the first lien agent’s lien on particular assets of the Valley View Debtor. The first lien agent objected to these discovery requests on the basis that, among other things, they violated the intercreditor agreement. The second lien agent, taking a similar position to the second lien lender in Ion Media, argued that it was not violating the intercreditor agreement because it did not believe the assets at issue were "collateral," and the intercreditor only governed the parties’ rights with respect to the same. Moreover, the second lien agent asserted that the intercreditor agreement permitted the second lien claimholders (subject to limitations) to exercise rights and remedies against the debtors as "unsecured creditors."11
Under the security agreement, the debtors granted the first lien agent a first priority lien on all of their assets, including general intangibles and proceeds thereof, excluding certain specific property. Through the confirmation discovery process, the second lien agent wanted to test the scope of the first lien agent’s asserted liens and hoped to demonstrate that certain assets fell into the "excluded collateral" category. Specifically, the second lien agent argued that because the security agreement included an excluded collateral concept, "there was a universe over which [the first lien agent] did not have a lien . . . [and the second lien agent had] the right to challenge what constitute[d] that universe."12 The bankruptcy court disagreed with the second lien agent’s argument and found that much of what it asserted was a lien challenge and the intent and language of both the intercreditor agreement and final cash collateral order were designed to "box" the second lien agent out of the same.13 Though the posture was a discovery motion, the bankruptcy court’s ruling in Centaur effectively cut off merits discovery by the second lien agent and can be interpreted as accepting the argument that the effect of the waiver was to permit the first lien lenders to unilaterally declare what was covered by the collateral descriptions in the security documents without contest from the second lien parties.
In re Boston Generating
Following the school of thought requiring a waiver in a prepetition intercreditor agreement to be express, Judge Chapman of the Bankruptcy Court for the Southern District of New York determined that a provision in an intercreditor agreement that gave the first lien lenders the exclusive right to "make determinations regarding the release, sale, disposition or restrictions with respect to the Collateral" did not prohibit second lien lenders from objecting to the bid procedures or sale motion in a §363 sale process where the intercreditor agreement did not contain an "express or intentional waiver of [such] rights."14
The debtors in Boston Generating operated power plants that provided electricity to the Boston area. A collateral agency and intercreditor agreement governed the relationship between the debtors’ first and second lien creditors. Section 3.1(b)(i) of the intercreditor agreement provided, in pertinent part, that "[u]ntil the Discharge of First Lien Obligations has occurred . . . the First Lien Collateral Agent . . . shall have the exclusive right to enforce rights, exercise remedies . . . and make determinations regarding the release, sale, disposition or restrictions with respect to the Collateral without any consultation with or the consent of the Second Lien Collateral Agent or any Second Lien Secured Party[.]"15
The first lien agent contended that, based on the terms of the intercreditor agreement, the second lien claimholders lacked standing to object to the sale. The second lien parties disagreed, arguing that while there was no obligation for the first lien lenders to consult with the second lien with respect to a sale or other action covered by section 3.1(b)(i), these terms should not be read to require the second lien claimholders to stay silent with respect to the sale.
The bankruptcy court found the determination to be a "very close call[,]" opining that although "it goes against the spirit of the subordination scheme in the Intercreditor Agreement to allow the Second Lien Lenders to be heard and to attempt to block the disposition of the Collateral supported by the First Lien Agent, I am . . . constrained by the language of the Intercreditor Agreement. After extensive briefing and oral argument as well as detailed review of the Intercreditor Agreement, the Court finds no provision which can be read to reflect a waiver of the Second Lien Agent’s right to object to a 363 sale motion, either in its capacity as a Secured Party or in its capacity as an unsecured creditor."16 The court distinguished Ion Media, noting that the facts before it required a different outcome because (i) the proposed sale of substantially all of the debtors’ assets outside a plan would, if approved, effectively deprive the second lien lenders of the opportunity to vote, in an economically meaningful way, on a plan, and (ii) the second lien lenders were on the "cusp" of a recovery and were not engaging in the type of obstructionist behavior displayed in Ion Media.
In re TCI 2 Holdings, LLC
In TCI 2 Holdings, LLC (Trump Entertainment Resorts, Inc.), the Bankruptcy Court for the District of New Jersey held that §1129(b) of the Bankruptcy Code does not require compliance with provisions of an intercreditor agreement if the remaining requirements for a cram-down plan are satisfied.17
Trump Entertainment Resorts, Inc. and its affiliated debtors owned or managed three hotel casino properties in Atlantic City, New Jersey. As of the February 2009 petition date, the debtors owed approximately $488 million in first lien debt and $1.125 billion in second lien notes. The first lien lenders proposed a plan that converted the entire amount of the first lien debt into equity. The second lien noteholders proposed a plan (supported by the debtors) under which the first lien lenders would receive deferred cash payments and a new secured term loan payable at a market rate of interest and the second lien noteholders would receive the right to participate in a rights offering for up to 70 percent of the equity in the reorganized debtors.
The first lien lenders argued that the second lien plan violated the intercreditor agreement for two primary reasons: (i) by proposing to make deferred cash payments to the first lien lenders and distributions of cash, rights and other property to the second lien noteholders, the second lien plan contravened the intercreditor agreement’s requirement for second lien noteholders to turn over any shared collateral proceeds until the first lien lenders were paid in full, in cash, and (ii) by recharacterizing adequate protection payments made to the first lien lenders as payments of principal, the second lien plan violated the second lien noteholders’ waiver of the right to object to adequate protection payments to the first lien lenders, or to contest the status of the first lien lenders’ secured claims. In response, the second lien noteholders argued that the intercreditor agreement permitted them to exercise rights and remedies as unsecured creditors against the debtors, and there was no express term prohibiting the filing of a competing plan.
The bankruptcy court ultimately sided with the second lien noteholders and found that any breach of the intercreditor agreement would not impede confirmation of the proposed second lien plan. In forming its conclusion, the bankruptcy court relied on the introductory phrase of §1129(b)(1) — "notwithstanding section 510(a) of this title" — and interpreted this phrase to remove §510(a)18 from the scope of §1129(a)(1). While the first lien lenders did not convince the bankruptcy court that the second lien plan was unconfirmable, they did succeed in demonstrating that the second lien plan’s proposed release — on a nonconsensual basis — of the first lien lenders’ rights under the intercreditor agreement was not permissible under Third Circuit law, leaving the intercreditor issues to another court.19
In the spring of 2010, the Second Circuit issued a long awaited decision affirming in part and reversing in part rulings of the District Court for the Southern District of New York, some of which dated as far back as 2005.20 The central issue was whether second lien lenders could receive certain subscription rights and interests following a sale of the debtor’s assets, where the first lien lenders had not yet been paid in full, in cash, as required by the intercreditor agreement.
WestPoint Stevens was engaged the business of manufacturing and distributing textiles. In 2003, due to continued financial difficulties, the company concluded it was in the best interest of its creditors to commence bankruptcy proceedings. The debtor eventually realized that reorganization was not achievable due to the fact that two sets of secured creditors insisted on holding a controlling interest in the reorganized entity. The first lien creditor group was led by lenders holding approximately 54 percent of the first lien debt. The second lien creditor group was led by a cross-over lender that held approximately 51 percent of the second lien debt and 40 percent of the first lien debt. The debtor therefore concluded that a sale of its assets pursuant to §363 of the Bankruptcy Code was the only viable solution. An auction was held, and the second lien lender controlled group emerged as the winning bidder.
The intercreditor and lien subordination agreement between the first and second lien lenders provided that "[u]ntil all First Lien Indebtedness has been paid in full in cash . . . the Second Lien Lenders shall not be entitled to . . . exercise any rights or remedies with respect to the Second Priority Liens or the Collateral[.]"21 There were several exceptions to this provision, including the right of the second lien lenders to receive adequate protection payments and certain "permitted mandatory prepayments." The meaning of these exceptions was briefed and litigated extensively at the bankruptcy court, district court and circuit court levels.
On a timely appeal from the bankruptcy court’s sale order, the district court found that the distribution of certain interests to the second lien lenders violated the provision in the intercreditor agreement requiring the first lien lenders to be satisfied in full before any distributions to the second lien lenders could be made. The case was remanded to the bankruptcy court, which implemented the district court’s decision by requiring certain interests, including securities and interests that had already been distributed to the second lien lender group, to be distributed to the agent for the first lien lenders.22
The Second Circuit reversed, holding that §363(m) of the Bankruptcy Code barred the district court from directing the modification of the sale order in such a manner because it removed the second lien lenders’ control over the debtor’s business, which they had bargained for in the sale process. The court noted that §363(m) creates a rule of "statutory mootness," which limits the reviewing court’s jurisdiction such that, in the absence of a stay of the sale order, it only retains the authority to review challenges to the good faith aspect of the sale. While there is a narrow exception for challenges that are "so divorced from the overall transaction that the challenged provision would have affected none of the considerations on which the purchaser relied[,]" that exception was of no avail to the first lien lenders because the second lien lenders’ control of the debtor’s business was an integral part of the sale order.23 A stay stipulation entered into among the parties was also not determinative because it "permitted the transfer of assets and the lien release, claim satisfaction, and distribution to occur as a single integrated transaction."24
The Second Circuit did, however, conclude that the originally contemplated distribution of securities and interests to the second lien lenders violated the intercreditor agreement because the first lien lenders had the right to be paid in full, in cash.25 The problem at this stage of the case was what remedy the court could order. For the second lien lender group to maintain the control they bargained for during the sale process, the order had to require distribution of subscription rights to the second lien lender group to the extent necessary to enable it to secure 50.5 percent of the common stock of the new entity. After the second lien lender group received its requisite distribution and certain distributions to minority members of the second lien lenders were effected (as authorized in the sale order), the court was left with approximately 11 percent of the at-issue securities, which it directed should be allocated to the first lien lenders (other than the cross-over lender that led the second lien group) as a remedy for the erroneous ruling related to the first lien lenders’ priority rights to payment in full, in cash.
In re Erickson Retirement Communities, LLC
Finally, following the reasoning of Ion Media, the Bankruptcy Court for the Northern District of Texas ruled in Erickson Retirement Communities that a provision of a claim and lien subordination agreement prohibited a subordinated creditor from moving for appointment of an examiner in the debtors’ chapter 11 case.26
Erickson Retirement Communities and 16 affiliates filed for chapter 11 protection on October 19, 2009. Less than two months into the case, certain subordinated creditors filed a motion for appointment of an examiner to investigate numerous areas of inquiry. The court acknowledged that if it were forced to rule on the merits of the motion it would have found itself obligated under its reading of §1104(c) of the Bankruptcy Code to appoint an examiner because the request was made by a creditor before the confirmation of a plan and the debtor’s fixed, liquidated unsecured debts exceeded $5,000,000. The court took up as a threshold issue, however, the subordinated creditors’ standing to bring the motion as prerequisite to consideration of the merits.
In support of their argument, the senior lenders cited the intercreditor agreement’s provision prohibiting the subordinated creditors from "exercis[ing] any rights or remedies or tak[ing] any action or proceeding to collect or enforce any of the Subordination Obligations."27 The subordinated creditors countered that like any other ‘party-in-interest,’ they had the right to bring the motion under §1104(c). The court ultimately sided with the senior lenders, holding that the subordinated creditors were prohibited from filing the examiner motion, even if the action was not specifically addressed in the intercreditor agreement, because the subordinated creditors filed the motion with the indirect intention of challenging the value being allocated to the senior lenders and increasing collection on the junior claim. The bankruptcy court said it would not articulate what types of case participation by the subordinated creditors would be permitted under the intercreditor agreement, but it did hold that the "pursuit of the Examiner Motion (…where the apparent goal… is to challenge value being allocated to senior, secured creditors) is the type of ‘remedy’ prohibited by the [intercreditor agreement]."28
Implications Going Forward
As noted above, three factors may help parties assess how a bankruptcy court will interpret their intercreditor agreement: (i) whether the agreement explicitly addresses the action that the senior creditor seeks to prevent, (ii) whether the action at issue implicates the "bankruptcy imperative" and (iii) whether the court views the subordinated creditor as obstructionist.
On the spectrum of junior creditor action arguably barred by intercreditor agreements, the second lien lender’s efforts in Ion Media were viewed by the court as both (i) obstructionist and (ii) specifically addressed (and prohibited) by the intercreditor agreement. The Erickson court expanded on Ion Media by prohibiting an action not expressly barred under the intercreditor agreement, concluding that the sprit of the agreement was to prevent obstructionist junior creditor behavior and the examiner motion was in fact obstructionist. However, the court’s generous interpretation of the broad waiver provision raises difficulty in predicting what type of subordinated creditor action would be permitted by the provision at issue in Erickson.
Both the Ion Media and Erickson court framed the decision as one of standing; however, more recent cases, such as Centaur and Boston Generating, trend towards disfavoring standing arguments in light of the Bankruptcy Code’s inclusiveness of all parties-in-interest and the bankruptcy court’s use of the "bankruptcy imperative" to guard certain core rights. Instead, Centaur and Boston Generating reveal a focus on whether there had been an explicit waiver of a right. In Boston Generating, the court ultimately held that the waiver was not unequivocal whereas in Centaur the right to contest liens was plainly relinquished. In addition, both courts signaled throughout the cases that there may be instances in which policy considerations rise above a pre-petition bargain struck between creditors.