Given the commonality in today’s marketplace of complex corporate capital structures that employ multiple layers of secured debt, existing and potential creditors need to be increasingly aware of the rights and limitations provided for in subordination or intercreditor agreements. These agreements are often entered into between the existing lender or debt holder and a new lender. They often restrict the actions of subordinated lenders upon the debtor’s filing for bankruptcy protection, including denying their right to vote on the debtor’s plan of reorganization. More restrictive subordination agreements enable senior lenders to vote the claim of the junior lender in a way that favors the senior lenders even if such a vote eliminates any potential for distribution to the junior lender.
In the recent decision of In re Coastal Broadcasting Systems, Inc., a New Jersey district court affirmed the bankruptcy court decision confirming the debtor’s (“Coastal”) plan of reorganization and finding that an assignment of vote provision in a subordination agreement (the “Subordination Agreement”) is enforceable under both bankruptcy and state law. Such finding silenced the junior lender’s protests over its ability to use its claim and vote against Coastal’s proposed plan of reorganization. According to the district court, Subordination Agreements and their provisions are binding contracts. As with most types of contracts, parties are free to contract away certain rights, including rights to vote in the context of a bankruptcy proceeding.
The junior lenders (the “Junior Lenders”) in Coastal were both Coastal’s equity holders and holders of its secured promissory notes. Pursuant to the Subordination Agreement, the promissory notes were junior in priority to another holder of secured debt (the “Senior Lender”). The Subordination Agreement provided that in any reorganization proceeding the Senior Lender is “irrevocably authorized to … take such other actions (including without limitation, voting the Subordinated Debt) as it may deem necessary or advisable[.]”
Thereafter, Coastal filed its chapter 11 bankruptcy case, during which Coastal and the Junior Lenders filed competing plans of reorganization. At the hearing to approve Coastal’s plan, the Senior Lender asserted that the Subordination Agreement grants it the exclusive right to vote on the plan on the Junior Lenders’ behalf and that the Senior Lender would use the Junior Lenders’ claim to vote in favor of Coastal’s plan. The Bankruptcy Court analyzed the Subordination Agreement to determine whether the Senior Lender was entitled to vote the claims of the Junior Lenders and, if so, whether such contractual assignment of voting rights is enforceable in bankruptcy. The bankruptcy court answered both of these questions in the affirmative. It found that the Subordination Agreement unequivocally assigns the Junior Lenders’ voting rights to the Senior Lender with respect to the Junior Lenders’ promissory notes and that such assignment of voting rights does not violate the Bankruptcy Code and is not otherwise prohibited by non-bankruptcy law. The Senior Lender’s ability to vote the Junior Lenders’ claims in a self-serving manner enabled Coastal to confirm its plan, leaving the Junior Lenders without a distribution.
The Junior Lenders appealed to the district court, arguing that the Subordination Agreement did not entitle the Senior Lender to vote the Junior Lenders’ claims because the assignment of voting rights is prohibited by the Bankruptcy Code for the following four reasons: (i) the enforceability of subordination agreements under Bankruptcy Code § 510(a) does not apply to voting rights; (ii) the assignment of the voting rights in the Subordination Agreement conflicts with Bankruptcy Code § 1126(a), which arguably permits only “[t]he holder of a claim” to accept or reject a plan; (iii) voting rights are not assignable because allowing their assignment would violate public policy; and (iv) the assignment of the voting rights in the Subordination Agreement conflicts with Bankruptcy Rule 3018, which limits voting rights to “the creditor or equity security holder or authorized agent.”
The district court interpreted the Subordination Agreement under state law. Applying New Jersey law, the district court rejected the Junior Lenders’ arguments. First, the district court found that a bankruptcy proceeding was one of the various types of proceedings that triggered the assignment of voting rights under the Subordination Agreement. Second, it found that through the Subordination Agreement the Junior Lenders “irrevocably authorized [the Senior Lender] to … take such other actions (including without limitation, voting the Subordinated Debt) as it may deem necessary or advisable[.]” Under the terms of the Subordination Agreement, “Subordinated Debt” included the promissory notes held by the Junior Lenders.
Because the Subordination Agreement permitted the Senior Lender to vote the Junior Lenders’ claims in any proceeding including a bankruptcy proceeding, the district court found that the Senior Lender was permitted to vote the Junior Lenders’ claims under the terms of the Subordination Agreement. In so holding, the district court disagreed with other bankruptcy courts around the country, which have held that pre-petition assignment of voting rights through subordination agreements is not enforceable based on public policy and other grounds. The district court found no support in the Bankruptcy Code for the Junior Lenders’ arguments in favor of restricting the assignment of plan voting rights and instead held that creditors’ rights, including creditor voting rights, can be freely contracted away.
The subordinated creditors in Coastal Broadcasting lost their right to vote on a plan of reorganization by the pre-petition assignment of their voting rights to the Senior Lender through the Subordination Agreement. This holding deviates from other bankruptcy court decisions and is a wake-up call for secured creditors negotiating away bankruptcy rights under subordination agreements hoping that such concessions would not be enforced. As illustrated by the district court in Coastal Broadcasting, pre-petition assignments of voting rights may be enforceable despite other bankruptcy court rulings to the contrary. Until the split among bankruptcy and district courts is resolved by a higher court, legal professionals and lenders should pay close attention to the laws in their jurisdiction because their rights under a subordination agreement may be affected.