In Caterpillar Financial Services Corporation v. Peoples National Bank, N.A. (March 4, 2013), the US Court of Appeals for the Seventh Circuit, applying Illinois law, held that, under the “partial subordination” approach to lien subordination agreements, a junior creditor could move into a first-priority position by entering into a lien subordination agreement with the first-priority creditor, even moving ahead of other creditors not party to such lien subordination agreement that would otherwise be more senior. However, the court further held that, because the subordinating creditor could not produce a valid security agreement in accordance with the UCC, its security interest was unenforceable, and the junior creditor could not move ahead in priority to the disadvantage of a third-party creditor.
The Caterpillar case involved three different loans to S Coal as a single debtor: from Peabody Energy Corporation (Peabody) in 2005, Caterpillar Financial Services Corporation (Caterpillar) in 2006 and Peoples National Bank, N.A. (Bank) in 2008. Each loan was secured by the same pool of mining equipment, and each creditor filed a UCC financing statement at the time of its loan. S Coal eventually defaulted on all three loans. Given the general rule that a creditor that files its financing statement earlier generally has priority, the priority of the creditors with respect to the collateral would ordinarily be, from senior to junior, (i) Peabody, (ii) Caterpillar and (iii) Bank.
In this case, in connection with Bank’s loan, Peabody agreed to subordinate its security interest to Bank’s, with the hope that Bank’s loan would improve S Coal’s chances of salvaging its business and repaying the Peabody loan.1 Caterpillar was not party to this subordination agreement. The question then arose whether Bank, by virtue of the subordination agreement, could “jump ahead” of Caterpillar and assume Peabody’s first priority.
The Seventh Circuit held that, under the majority approach (as followed in Illinois), the “partial subordination” rule would simply swap the priorities of the parties to the lien subordination agreement; therefore, the priorities, after giving effect to the lien subordination agreement, would be (i) Bank, (ii) Caterpillar and (iii) Peabody. Under the minority “complete subordination” rule, which was not applied by the Seventh Circuit,2 the subordinated creditor would simply drop to the back of the line, in which case the priority would be (i) Caterpillar, (ii) Bank and (iii) Peabody. Note that Peabody would end up with last-place priority in either event.
Notwithstanding the potential effectiveness of the lien subordination agreement in allowing Bank to jump ahead of Caterpillar, the court found that Peabody’s original security interest was not perfected because Peabody could not, pursuant to Section 9-203(b)(3)(A) of the UCC, produce a security agreement authenticated by the debtor that provided a description of the collateral. Accordingly, because Bank’s claim for a first-priority security interest was derivative of Peabody’s, Bank could not jump ahead of Caterpillar’s prior-perfected security interest.
Although it was not dispositive in this case, the court further found that, assuming the enforceability of all parties’ security interests, the “partial subordination” rule would permit the junior creditor to jump ahead only to the extent of the subordinating lender’s first-priority security interest. So, for example, if Peabody were owed $1 million and Bank were owed $4 million, Bank would only have first priority with respect to $1 million worth of collateral, and would otherwise be junior to Caterpillar in enforcing remedies with respect to the remaining $3 million balance of its loan.3
The Caterpillar case suggests that, at least under the majority approach and Illinois law, a financial institution, considering whether to extend credit to a potential borrower with other creditors, could strengthen its collateral position by entering into a lien subordination agreement with a more senior creditor. And, if the additional credit could improve the senior creditor’s likelihood of being repaid, then such senior creditor may be amenable to such an approach.
However, any junior creditor should carefully due diligence the documentation creating and perfecting the security interest of the more senior creditor, including security agreements and UCC financing statements, prior to implementing any such strategy. Note also that the party relying on such a subordination agreement to obtain the priority of a prior secured creditor that actually had a perfected security interest would bear the risk that such creditor ceased to be so perfected due to a change in circumstances after the subordination agreement was signed, such as by failing to continue the effectiveness of a financing statement or by failing to take appropriate steps in the event the debtor changed its location or its name.