One of the more effective risk-mitigation legal tools used by senior real estate lenders is the single purpose entity borrower. Among other things, having a single purpose, bankruptcy remote borrower makes avoiding the risks of bankruptcy easier. Even in bankruptcy, if the borrower is truly single purpose, and it keeps the universe of creditors small, the senior secured lender will have an easier time defeating any plan of reorganization proposed by the borrower because it will control all of the legitimate classes of creditors by virtue of the voting rights associated with its large, usually undersecured claim.
Sometimes, however, a borrower will need junior debt, and sometimes that debt will not be available on a mezzanine basis. If the senior secured real estate lender is willing to permit a junior loan, it generally will want to tie the hands of the junior creditor as tightly as possible, in either an intercreditor or subordination agreement. One of the ways senior secured lenders implement this hand-tying is to have the junior creditor “assign” to the senior lender its right to vote on any plan of reorganization in a borrower bankruptcy. If such an assignment is enforceable, the senior secured lender will be able to maintain the possibility of controlling the voting in all the creditor classes in a borrower bankruptcy, thereby preventing confirmation of a plan without its consent.
The assignment of the voting rights of the junior lender is important because of the way confirmation of a plan works under the Bankruptcy Code. Section 1122 provides that a plan of reorganization must provide for classes of creditors, and that classes must contain claims that are similar. In most single asset real estate cases, there should be only two classes of creditors - a class of secured claims, which is typically the secured claim of the senior secured lender, and a class of unsecured claims. The class of unsecured claims usually includes the unsecured portion of the senior lender’s claim - the amount by which the senior lender’s claim exceeds the value of the collateral. Section 1129 of the Bankruptcy Code contains the requirements for confirmation of a plan. Section 1129(a)(10) requires that, to be confirmed, a plan must have at least one class of creditors that is both impaired under the plan and that accepts the plan. Under Section 1126, a class accepts a plan if the creditors in the class accept the plan by 2/3 in dollar amount and 1/2 in number. So, in a simple case involving a single asset borrower and two classes of claims (secured and unsecured), the secured lender would have a veto over any plan in the case so long as its unsecured claim amounted to more than 1/3 of the overall amount of unsecured claims, because the secured lender would be able to cause both classes to vote “no” on any plan.
In cases involving real estate assets, the fight is normally over the unsecured class or classes, and how such classes are constructed. Borrowers often try to create more than one unsecured class (often called “gerrymandering”), hoping to create one that it can impair and that will vote for the borrower’s plan. Borrowers will sometimes “artificially impair” that class - for example, they will pay the class in full 30 days after the effective date, even though the borrower has the cash on hand on the effective date to make the payment - with the delay purportedly constituting “impairment” of the class. Gerrymandering and artificial impairment are regularly litigated issues in real estate bankruptcy cases. However, if there is junior secured debt, and the debtor can reach an agreement on plan treatment with the junior secured creditor (whose claim can more easily be separately classified), the borrower’s plan can satisfy 1129(a)(10) without any attempt at “gerrymandering” the unsecured claims or creating an “artificially impaired” class. If, on the other hand, the senior lender controls the vote of the junior lender, that option is not available, and confirmation of a plan over its objection returns to the configuration described above - where the senior secured lender often has an effective veto.
Courts have split on the enforceability of an assignment of voting rights in bankruptcy. The first few cases on the subject found that such assignments were unenforceable. In re Hart Ski Mfg. Co., 5 B.R. 734 (MN 1980); In re 208 N. LaSalle Street, 246 B.R. 325 (ND IL 2000). In short, these courts found the assignment to be unenforceable for four (4) reasons:
- Section 1126 of the Bankruptcy Code says that a “creditor” may vote its claim, and the Bankruptcy Code cannot be overridden by agreement;
- Section 510 of the Bankruptcy Code, which confirms the enforceability of subordination agreements in bankruptcy, does not support enforcement of provisions in such agreements other than those that result in subordination;
- Federal Rule of Bankruptcy Procedure 3018(c), which permits voting by an “agent”, does not lead to a contrary result, because Bankruptcy Rules cannot contradict the Bankruptcy Code, and because an agent must act in the interest of its principal; and
- Enforcing such provisions would eliminate a junior creditor’s role in the bankruptcy case, which is bad policy.
Hart Ski and 208 N. LaSalle Street created serious question about the enforceability of the assignment of voting rights in a bankruptcy case, as there was for a time no contrary case law. Then in 2006 Judge Margaret Murphy addressed the enforceability of voting rights assignments in In re Aerosol Packaging, LLC, 362 BR 43 (GA -2006), a case in which the author represented the senior secured creditor. In Aerosol Packaging, Judge Murphy held that:
- Section 510 of the Bankruptcy Code says that subordination agreements are enforceable to the extent enforceable under state law, and there was no indication in that case that the voting rights assignment at issue was not enforceable under applicable Georgia contract law;
- Section 1126 of the Bankruptcy Code gives voting rights to a “creditor”, but does not address at all whether those rights can be assigned or bargained away; and
- Federal Rules of Bankruptcy Procedure 3018 and 9010 say that agents may vote claims - and some agents (i.e agencies coupled with an interest) can and do act for their own benefit and not for that of the principal.
Cases since Aerosol Packaging have come down on both sides of issue. In re Coastal Broadcasting Systems, Inc. 2012 WL 2803745 (NJ 2012)(enforced); In re Croatan Surf Club, Inc., 2011 WL 59099199 (NC 2011)(not enforced); Matter of Avondale Gateway Center Entitlement, LLC, 2011 WL 1376997 (AZ 2011) (enforced).
The Matter of Avondale case may be the most interesting of these, since the agreement at issue there did not even contain any express language assigning voting rights. Instead, the court relied on the following subrogation provision:
“[Junior] agrees that [senior] shall be subrogated to [junior] with respect to [junior’s] rights, liens, and security interests, if any, in any of the Borrower’s assets and the proceeds thereof (excluding, however, [junior’s] right under any pledge of Borrower’s membership interests made under the Subordinate Debt Documents) until the Senior Debt shall have been paid in full.”
From that language, the Court inferred an assignment, and then found such an inferred assignment to be enforceable.
The issue of the enforceability of assignments of voting rights is an important one. The ability to obtain voting rights from a junior creditor supports the overall structure of the single asset bankruptcy remote borrower. Although case law continues to develop in this area, there is no certainty as to how the issue will ultimately be resolved. In the interim, senior secured lenders should consider some of the following measures to enhance the chances of their clauses being enforced:
- Be as specific as possible about the assignment of the right to vote. Consider reference to specific Bankruptcy Rules;
- Consider providing for the assignment to the senior secured lender of the junior lender’s entire claim, not just the assignment of the right to vote, or obtaining an option to buy the junior claim for a nominal amount (excluding, possibly, in either case, the right to a distribution under such claim).