After several years of unusually few corporate defaults, there has recently been an uptick in corporations failing to satisfy their bond and loan obligations. In a number of cases, the debts in question are part of multiple-lien or multi-tranche financing structures that incorporate complex subordination packages. The agreements at issue often go beyond merely subordinating rights to payments. Instead, such agreements often also entail waivers by the junior creditors of various bankruptcy protections that they would otherwise possess, including the right to vote on plans of reorganization or to object to such plans. But are such waivers actually enforceable? Frustratingly, the answer is “sometimes.”
510(a) of the Bankruptcy Code
Section 510(a) of the Bankruptcy Code states that a “subordination agreement is enforceable . . . to the same extent that such agreement is enforceable under applicable nonbankruptcy law,” meaning state contract law. The Bankruptcy Code is silent, however, as to the enforceability of agreements that contain not only a subordination clause (i.e., a clause that alters priority of payment rights as between two parties), but also other provisions that affect the parties’ respective rights in bankruptcy. Remarkably, very few cases have addressed whether such agreements constitute enforceable “subordination agreements.” Instead, when a dispute arises, courts usually begin their analysis with a citation to section 510(a), and then simply discuss whether a particular provision is enforceable. Unfortunately, such decisions are splintered and provide little certainty that a subordination agreement that goes beyond mere subordination of payment rights will be enforced in full.
Certain Decisions Have Found Such “Broad Subordination” Provisions Unenforceable
Some courts have concluded that subordination agreements are only enforceable insofar as they address the relative priority of payments. These courts hold that provisions of subordination agreements that purport to waive other bankruptcy rights, such as the right to vote a claim or object to a plan of reorganization, are unenforceable in bankruptcy. For example, in In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000), the court was asked to consider whether an agreement that granted a senior lender the right to vote the junior lender’s claims in bankruptcy should be enforced. The court concluded that it should not be enforced, reasoning that “[s]ubordination . . . has a common understanding in the law [as] [t]he act or process by which a person’s rights or claims are ranked below those of others. . . . Subordination thus affects the order of priority of payment of claims in bankruptcy, but not the transfer of voting rights.” Previously, the court in In re Hart Ski Mfg. Co., Inc., 5 B.R. 734 (Bankr. D. Minn. 1980) reached a similar conclusion, reasoning “[t]he intent of § 510(a) (subordination) is to allow the consensual and contractual priority of payments to be maintained between creditors . . . . There is no indication that Congress intended to allow creditors to alter . . . the bankruptcy laws unrelated to distribution of assets.”
General Trend Towards Enforcement of Broad Subordination
Despite the 203 North LaSalle and Hart Ski decisions, most courts have enforced broad subordination agreements. For example, in Blue Ridge Investors, II, LP v. Wachovia Bank, N.A. (In re Aerosol Packaging LLC), 362 B.R. 43 (Bankr. N.D. Ga. 2006), the court was asked, as in 203 North LaSalle, whether a subordination agreement that contained an assignment of voting rights was enforceable. The Aerosol Packaging court explicitly rejected 203 North LaSalle and concluded that the voting rights assignment provision was enforceable, noting that bankruptcy rules 3018 and 9010 explicitly permit agents and other representatives to act on behalf of creditors.
Under very different facts, the court in In re Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D. Tex. 2010) also enforced a broad subordination agreement. In that case, certain subordinated creditors sought the appointment of an examiner despite having entered into a subordination agreement in which they agreed, among other things, not to exercise any of their remedies or take any action to collect on their claims without the prior consent of the senior lenders’ agent unless the claims of the senior lenders had already been satisfied in full. In that case, the agent refused to give his consent to the appointment of an examiner, and contended that the subordinated creditors’ request for the appointment of an examiner was an indirect request for payment. The court reasoned that a reasonable person would understand that, pursuant to the subordination agreement, subordinated parties were required to “stand still” until senior obligations were satisfied. The subordinated creditors’ violation of that principle was thus “the very type of obstructionist behavior that [subordination agreements] are intended to suppress.” Accordingly, the court enforced the stand still provisions and refused to appoint an examiner. Other courts have reached similar results after concluding that subordination agreements are intended to prevent obstructionist behavior by junior creditors. See, e.g., Ion Media Networks, Inc. v. Cyrus Select Opportunities Master Fund (In re Ion Media Networks, Inc.), 419 B.R. 585 (Bankr. S.D.N.Y. 2009).
Recent Anti-Enforcement Decisions
Although some commentators have observed a growing trend towards enforcement of broad subordination agreements, two recent decisions have called that trend into question. In In re Croatan Surf Club, LLC, No. 11-00194-8, 2011 WL 5989199 (Bankr. E.D.N.C. Oct. 25, 2011), the court faced almost exactly the same issue as that raised in 203 North LaSalle and Aerosol Packaging. Prepetition, the debtor and two of its creditors entered into a subordination agreement under which, among other things, the junior creditor assigned to the senior creditor its right to file and vote its claims in the event the debtor filed for bankruptcy. How
ever, when the debtor filed for chapter 11 protection and proposed a plan of reorganization, both the senior and the junior creditor attempted to vote the junior creditors’ claim.
In deciding which vote to accept, the bankruptcy court explicitly adopted the reasoning of 203 North LaSalle and found that only the junior creditor possessed the right to vote its claim. According to the court, “there is no reason to deviate from the plain language of § 1126(a),” which empowers the holder of a claim to vote that claim. When faced with the argument that bankruptcy rules 3018 and 9010 permitted the senior creditor, as the junior creditor’s appointed agent, to vote on the junior creditor’s behalf, the court held that no such agency existed because “agency involves action at the direction of a principal,” whereas the senior creditor voted the junior creditor’s claim at its own discretion.
Mere days after the Croatan Surf Club decision, the court in In re SW Boston Hotel Venture LLC, 460 B.R. 38 (Bankr. D. Mass. 2011) issued a virtually identical decision under similar facts. As in Croatan Surf Club, the court was asked to decide whether a senior creditor could vote a junior creditor’s claim in accordance with a subordination agreement when the junior creditor cast a competing ballot in violation of the agreement. Although the SW Boston Hotel Venture court did not cite Croatan Surf Club, it similarly adopted the reasoning of Hart Ski and 203 North LaSalle in concluding that a subordination agreement “cannot nullify provisions of the Bankruptcy Code.” In the face of contrary authority, including the Aerosol Packaging decision, the court held that 203 North LaSalle and Hart Ski were more persuasive.
Is Your Subordination Agreement Enforceable?
Unfortunately, under current law, there is no practical way to determine whether a particular subordination agreement that goes beyond mere subordination of payment rights is enforceable. Prior to the SW Boston Hotel Venture and Croatan Surf Club decisions, it was safe to say that a court would generally enforce a broad subordination agreement containing waivers of voting or other bankruptcy rights by the junior creditor. In light of those rulings, however, the picture is more mixed. Decisions by bankruptcy courts in the Second, Third, Fifth and Eleventh Circuits have favored enforcement of subordination agreements that go beyond mere subordination of payment rights. Meanwhile, decisions from bankruptcy courts in the First, Fourth and Seventh circuits have reached a contrary conclusion. Worse, there is a distinct lack of authority from appellate courts on this issue. As a result, bankruptcy courts are likely to continue to address the enforceability of such provisions on an ad hoc basis.
Creditors who are parties to subordination agreements that contain waivers of bankruptcy rights should approach bankruptcy with the unsettled state of the law in mind. Senior creditors should be aware that while a broad subordination agreement may provide some leverage over a junior creditor that might not otherwise be available, it does not give senior lenders a bullet-proof method for excluding dissident junior creditors from the decision-making process. Likewise, junior creditors should be aware that if cooperation with a senior creditor becomes untenable, they may have more room to maneuver than a plain reading of a subordination agreement might suggest.