Over the past several years, much has been written about how numerous bankruptcy courts have interpreted and enforced bankruptcy and insolvency-related provisions in intercreditor agreements, subordination agreements and other “agreements among lenders” when they may affect a debtor and its estate. Although the Bankruptcy Code itself provides little guidance, the emerging trend has been for bankruptcy courts to strictly enforce intercreditor agreements according to their clear and unambiguous terms, rather than allow for broader interpretations based upon the parties’ intent or other policy considerations.

Intercreditor agreements are commonplace in loan transactions that involve multiple lenders, and set forth the relative rights, priorities and obligations of senior lenders verses junior or subordinated lenders—including priority of payment—and as to their common borrower and its assets. Section 510(a) of the Bankruptcy Code provides that a subordination agreement is enforceable in a bankruptcy case to the same extent it would be under applicable nonbankruptcy law. But bankruptcy courts have not always enforced these agreements consistently; some courts have enforced them as written, while others have invalidated certain provisions.

The recent trend is for bankruptcy courts to enforce as written intercreditor provisions that alter the respective rights of lenders, but only if the provisions are specific, clear and unambiguous. In other words, if a senior lender wants an alternative payment waterfall for the distribution of collateral or the proceeds of collateral among lenders in the event of an insolvency proceeding, the agreement must say so, clearly and specifically. Otherwise, the lender faces the risk that the provision will not be enforced.

A recent opinion from the U.S. Court of Appeals for the Third Circuit interpreting bankruptcy-related concepts (although not a case on appeal from a bankruptcy court) follows the current bankruptcy trend and reminds senior lenders of the importance of careful drafting if they want to restrict the rights of junior creditors, especially with respect to bankruptcy-related issues. We provide here an analysis of the court’s opinion and key takeaways for interested lenders.

The court’s opinion

On June 19, 2019, the Third Circuit found that “adequate protection payments” and “plan distributions” from a bankrupt company to its lenders (which are specific to bankruptcy cases), although generated from sales of collateral, were not in fact collateral or proceeds thereof and, therefore, were not subject to an intercreditor agreement’s waterfall provision regarding distribution of collateral. See Delaware Trust Co. v. Morgan Stanley Capital Group (In re Energy Future Holdings Corp.), No. 18-1957, 2019 WL 2535700 (3d Cir. June 19, 2019). The court’s ruling had ramifications for both of the lenders to the bankrupt borrower/debtor.

In the underlying bankruptcy case, the borrower/debtor owed money to two separate lenders whose loans were secured by the same collateral and with equal priority. As part of the loan transaction, the lenders entered into an intercreditor agreement which contained a waterfall provision to govern distributions of collateral or proceeds from the “sale, disposition, or collection of collateral.” After the borrower/debtor’s 2014 bankruptcy filing, both lenders received “adequate protection payments” from the Debtor for the use of their collateral. In 2016, the bankruptcy court approved the borrower/debtor’s plan of reorganization which required that both lenders give up any claims to their collateral in exchange for distributions of money they would receive under the approved bankruptcy plan. The lenders disagreed about how those adequate protection payments and plan distributions should be shared between them in light of the waterfall.

One lender sued the other lender for a determination of how the proceeds should be shared under their intercreditor agreement, and the case ultimately ended up on appeal to the Third Circuit. In affirming the decision of the lower court, the Third Circuit strictly construed the intercreditor agreement’s waterfall provision, closely analyzed the bankruptcy concepts, and determined that the adequate protection payments and plan distributions received by the lenders did not squarely fit within the intercreditor’s agreement’s definition of “collateral” or “proceeds of collateral.”

The intercreditor agreement imposed two possible alternative applications of the waterfall: (1) if the proceeds were from a sale, collection, or disposition of collateral, and (2) if the sale, collection, or disposition were part of a remedy implemented by the collateral agent.

With respect to the adequate protection payments, the Court rejected the senior lenders’ argument that the adequate protection payments were made out of “cash collateral” and subject to the allocation scheme under the intercreditor agreement. Because the adequate protection payments “did not decrease the amount of money [the debtor] owed”—rather, they were made “in exchange for the creditors’ agreement to let [the debtor] use the collateral for other purposes”—the Court denied that they were “payments of collateral” subject to the waterfall.

With respect to the plan distributions, the Court decided that they were made exclusively from assets that were received pursuant to the plan, which specified that the creditors’ liens did not extend to any of those assets. As such, the plan distributions were not distributions of “collateral” subject to the waterfall. Additionally, while the plan distributions might have met the first requirement (i.e., a sale or disposition), they did not meet the second requirement because the restructuring was not part of a remedy implemented by the collateral agent. Accordingly, the plan distributions were also not subject to the payment waterfall.

Ultimately, the Court held that each creditor would be entitled to payments and distributions based on what their borrower/debtor owed each of them upon the bankruptcy filing, without regard to the higher rate of interest that one of the lenders would have enjoyed post-petition had it not been for the bankruptcy.

Key Takeaways

While this decision is consistent with bankruptcy courts’ recent tendency to enforce intercreditor agreements strictly as written, this decision highlights the risks senior lenders may face when attempting to enforce their intercreditor agreements against junior lenders in bankruptcy and insolvency-related situations. Unless intercreditor agreements, subordination agreements and other agreements among lenders are clearly and carefully drafted, they may not be enforced by the courts as the parties intended or as broader big-picture bankruptcy concepts may otherwise dictate.

As discussed above, the Third Circuit closely analyzed the bankruptcy concepts at play and adhered to the strict wording of the agreement and whether it squarely applied to such concepts, rather than to consider them more broadly in the context of the overall loan structure or relationship between lenders. However, had the intercreditor agreement specifically stated that the waterfall provision applied to adequate protection payments, plan distributions or other payments made by a chapter 11 debtor, the Court likely would have arrived at the opposite result. Senior lenders intending broader application of their intercreditor agreements to insolvency situations would be wise to take these considerations into account and to always incorporate a bankruptcy professional’s input early in the drafting of such agreements.