Intercreditor Agreements Face Bankruptcy Court Scrutiny – A Cautionary Tale

Most intercreditor agreements contain language setting out the parties' rights and limitations to obligations should their mutual borrower file for bankruptcy protection. These provisions not only modify the parties' priority of payment and distribution of assets, but also may include language that more substantially affects the parties' rights under the bankruptcy code.

Within the context of a Chapter 11 bankruptcy case, it is in the senior creditor's interest to gain control over the plan process to the maximum extent possible. Therefore, senior creditors often request provisions within intercreditor agreements that restrict a junior creditor's ability to vote independently within the plan process. The primary concern is that the junior creditor could take a position contrary to the interests of the senior creditor by either voting against a plan supported by the senior creditor or cramming the senior creditor down by voting in favor of an objectionable plan. The various intercreditor agreement provisions by which a senior creditor may further this goal include: (1) assignment of voting rights to the senior creditor or the agreement of junior creditor to vote as directed by senior creditor, (2) agreement not to vote against a plan supported by the senior creditor, (3) agreement not to vote for a plan that lacks certain terms or conditions, (4) agreement not to object to a proposed plan of reorganization that is consistent with the rights of the senior creditor under the intercreditor agreement and/or (5) restrictions regarding ability to propose a plan that senior creditor does not support.¹

The enforceability of the above mechanisms has recently been called into question. In the case In re SW Boston Hotel Venture, LLC, the Bankruptcy Court for the District of Massachusetts held the assignment of voting rights within an intercreditor agreement is not enforceable.²

The court reasoned that although § 510(b) of the bankruptcy code provides for the enforceability of subordination agreements, "such agreements cannot nullify provisions of the Bankruptcy Code," and "[t]o the extent a provision in a subordination agreement purports to alter substantive rights under the Bankruptcy Code, it is invalid."³

The court elected to follow and adopt the reasoning of the Northern District of Illinois Bankruptcy Court in the decision Bank of Amer. v. N. LaSalle Street Ltd. P'ship, in which the Illinois Bankruptcy Court reasoned that a creditor cannot waive plan voting rights because Congress did not intend to permit creditors to alter substantive provisions of bankruptcy law.⁴ The argument behind the Bank of Amer. v. N. LaSalle decision is premised upon the general rule that pre-bankruptcy agreements do not override contrary provisions of the Bankruptcy Code, as it would defeat the very purpose of the Bankruptcy Code. Further, subordination, by its very definition, encompasses the priority of payment of claims and not the transfer of voting rights. Although a creditor's claim may be subordinated, that creditor may still have a substantial interest in its treatment under a proposed plan. And finally, there is no reason to deviate from the plain definition and language of § 1126(a).⁵

The court acknowledged the contrary line of decisions, including Blue Ridge Investors, II, LP v. Wachovia Bank, but found the Bank of Amer. v. N. LaSalle Street Ltd. reasoning to be more persuasive.⁶ This contrary line of cases stands for the proposition that parties are free to enter into subordination contracts with each other so long as the agreement is enforceable under applicable non-bankruptcy law pursuant to § 510(a). These cases also do not view the plain language of § 1126(a) as an impediment, as it merely grants a right to vote but is silent as to whether the party to whom that right is granted may delegate it to another or bargain it away.⁷

In applying the Bank of Amer. v. N. LaSalle Street Ltd. reasoning, the court accepted the junior creditor City of Boston's ballot voting to accept and held to be invalid the senior creditor Prudential Insurance Company's ballot voting to reject the plan submitted on behalf of the City of Boston.⁸ This holding was despite the parties' intercreditor agreement, the language of which explicitly provided that in the event of a bankruptcy, the City of Boston would assign its voting rights to Prudential.⁹ The court also noted that despite its holding, the voting dispute between the City of Boston and Prudential was irrelevant because there were other impaired classes voted to accept the Plan. Therefore, the plan would still have been confirmed over Prudential's objection pursuant to the cramdown provisions of § 1129(a)(10).¹⁰

Ultimately, the court's discussion in In re SW Boston, even if it is dictum, highlights the uncertainty surrounding the enforceability of voting assignment and other similar intercreditor agreement provisions that may be construed as impermissibly altering substantive rights under the bankruptcy code. It also highlights the ripeness of this issue for further determination by appellate courts. When crafting intercreditor agreements, lenders should be conscious of the potential limitations of these provisions. Specifically, it is best to draft the provisions as favorably as possible without relying upon language that may be construed as affecting the parties' substantive rights under the bankruptcy code, with an eye to the existing case-law within the expected jurisdiction of enforcement.

A potential mechanism for avoiding the holding of In re SW Boston, which prohibits the naked assignment of voting rights, is for the subordinate creditor to agree to the assignment of its claim to the senior creditor upon the event of borrower's bankruptcy filing. The assigned claim would re-vest with the subordinate creditor upon the senior lender's payment in full of all amounts due and owing. This provision would be consistent with the provisions of most intercreditor agreements which prohibit the junior creditor from receiving payments following an event of default until the senior creditor is paid in full. This mechanism is attractive because it comports with the spirit of the Bankruptcy Code, which allows for the transfer of claims under Federal Rule of Bankruptcy Procedure 3001, it avoids the § 1126(a) argument set forth above, and it can be argued that the primary purpose of the provision is subordination and priority of payments as recognized within § 510. Although untested, this mechanism may prove to be an attractive alternative to the stand-alone assignment of voting rights.

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¹ Practical Law Company, Bankruptcy Provisions in Intercreditor Agreements, Practice Note, p. 17 (http://uslf.practicallaw.com/2-501-2054?q=intercreditor+agreement#null).
² 2011 WL 5520928 at *10 (Bankr. D. Mass. Nov. 14, 2011).
³ Id.
⁴ 246 B.R. 325, 331 (Bankr. N.D.Ill. 2000).
⁵ See also In re Croatian Surf Club, LLC, 2011 WL 5909199 (Bankr. E.D.N.C. 2011); Beatrice Foods Co. v. Hart Ski Mfg. Co., Inc., 5 B.R. 734 (Bankr. D. Minn. 1980); 
⁶ 362 B.R. 43 (Bankr. N.D.Ga. 2006).
⁷ See also In re Curtis Center Limited Partnership, 192 B.R. 648 (Bankr. E.D.Pa. 1996); In re Inter Urban Broadcasting of Cincinnati, Inc., 1994 WL 646176 (E.D.La. 1994).
⁸ 2011 WL 5520928 at *10.
⁹ The exception to this was the City of Boston's voting rights with respect to collateral upon which Prudential did not share a lien.
¹⁰ It is difficult to discern whether the holding on the voting issue made the Court's decision easier.