Silent Second Lien Financings Part II Are They Enforceable
Congress has acknowledged the validity of subordination agreements in §510(a) of the Bankruptcy Code. However, established enforcement of subordination in bankruptcy courts is subordination with respect to payment priority and not necessarily with respect to the subordination of rights and remedies. Whether bankruptcy courts will, or even can, enforce waivers contained in subordination agreements concerning the exercise of the junior creditor's rights and remedies is unclear, at best. There has long been debate concerning the enforceability of waivers obtained by lenders from debtors pre-petition concerning the waiver of certain rights after a bankruptcy petition is filed. In those cases, courts have been very reluctant to enforce any waivers agreed to by a borrower/debtor in advance of a bankruptcy filing and have determined that, barring exigent circumstances, such waivers are generally not enforceable.2 When looking at whether bankruptcy courts will enforce such waivers when agreed to in advance by sophisticated lenders, it certainly can be argued that the analysis is a very different one and it is not necessary for the bankruptcy court to play such a protective role. However, a strong argument can also be made that parties, no matter how sophisticated, should not be able to contract away statutorily afforded rights provided by the Bankruptcy Code that essentially override the priority scheme of the Bankruptcy Code.
A Look at the Cases
Different courts in different jurisdictions have reviewed many issues concerning the enforceability of waivers by second lien-holders to assert any rights to §363 sales, DIP financing, cash collateral, collection of the obligation, voting on reorganization plans and other similar waivers. The decisions have yielded differing results. Accordingly, no definitive answer has been established to the question of whether the generally accepted provisions in second lien transactions are enforceable once a bankruptcy petition is filed by the borrower.
In In re 203 North LaSalle Street Partnership,3 the bankruptcy court was faced with an action commenced by the senior creditor to enforce a provision in the subordination agreement that stripped the junior lien-holder's right to vote on a chapter 11 reorganization plan.4 The court upheld the payment subordination pursuant to the terms of the subordination agreement and specifically recognized the validity of subordination agreements pursuant to §510 of the Bankruptcy Code.5 However, the court determined that subordination affects only the priority of payment and that §510(a) does not allow for a waiver of voting rights pursuant to §1126(a) of the Code.6
However, in another case where voting restrictions were at issue, Inter Urban Broadcasting,7 a debtor, senior and junior creditor entered into a subordination and intercreditor agreement, pursuant to which, among other things, the junior creditor assigned and subordinated its claims, rights and collateral to the senior creditor until the senior creditor was paid in full.8 In the bankruptcy, the senior creditor tendered a competing plan that essentially provided for the senior creditor to receive partial repayment and the junior creditor to receive nothing. The senior creditor voted in favor of its plan on behalf of itself, and the junior creditor and the debtor objected. The bankruptcy court denied confirmation of the debtor's plan and confirmed the senior secured creditor's plan. The debtor appealed, and the case went to the district court. The district court noted that the junior creditor benefited from the senior loan and that no one had established that the agreement could not be enforced.9 Accordingly, the court upheld the intercreditor agreement and held that the senior creditor's vote on behalf of itself and the junior creditor was "proper and in accordance with the law."10
The Eastern District of Pennsylvania Bankruptcy Court dealt with voting issues as well as more broadly with intercreditor agreements.11 Pursuant to a separate agreement, the bank senior lender agreed to be subordinate to the senior working-capital lender. The borrower defaulted, filed a petition for relief under chapter 11 and sought to have a plan confirmed pursuant to which it had separately classified the senior and junior holders. The junior lien-holder voted in favor of the plan. The senior lender objected, noting that the junior lien-holder had no right to vote for or against the plan pursuant to the restrictions in the intercreditor agreement.12 The court noted that the senior lender had made it clear during the case that, pursuant to the subordination agreement, it had the right to vote the junior lender's claim and, as such, the plan could not possibly be confirmed. The court held that the unambiguous language of the subordination agreement was enforceable and that the debtor could not rely on the junior lien-holder's acceptance of the plan to satisfy the requirement of receiving an acceptance by an impaired class for purposes of "cramdown" pursuant to §1129(a)(10) of the Code.
Adequate Protection/Automatic Stay
In another case, a senior creditor sought the assistance of the bankruptcy court to prevent a junior creditor from seeking adequate protection or the lifting of the automatic stay based on language in the subordination agreement that, according to the senior creditor, deprived the junior creditor from exercising such rights.13 The bankruptcy court in Hart Ski refused to uphold the provisions at issue and ultimately held that Congress never intended that parties could alter, by subordination agreement, the bankruptcy laws unrelated to distribution.14 Specifically, the court noted that the Code guarantees each creditor rights regardless of subordination.
Proofs of Claim
As part of a silent second lien arrangement, it is common to provide in the intercreditor agreement that a senior creditor can file a proof of claim on behalf of a junior lien-holder. In Davis Broadcasting,15 two creditors of the debtor had entered into a "Continuing Subordination and Pledge Agreement," which gave the senior creditor superior lien rights over the junior creditor, as well as granted the senior creditor additional rights in the case of default and/or future bankruptcy. Specifically, the senior creditor was granted the right to file a proof of claim and vote in the event of a bankruptcy proceeding.16 A bankruptcy was filed, and the senior creditor filed the proof of claim and voted on its and the junior creditor's behalf in favor of the chapter 11 plan. The junior creditor did not object. A substantial consummation order was entered. More than a year later, the junior creditor petitioned the court to reopen the case to correct what it called an "error" in the confirmation process. The bankruptcy court, for all intents and purposes, enforced the Subordination and Pledge Agreement, noting that the junior creditor had freely entered into the subordination agreement and rejected the junior creditor's motion.17 Payment of Post-petition Interest to Senior Lien-holder
As noted in Part I, payment of post-petition interest to the senior lender can be an important issue. Due to the recent opinion issued by the First Circuit in Bank of New England,18 this area has received a lot of attention recently. Generally, intercreditor or subordination agreements provide that senior lien-holders must be paid in full prior to junior lien-holders receiving any payment. Until recently, it was generally accepted that if the document contained "precise, explicit and unambiguous" language indicating that the senior creditors would receive post-petition interest from funds that otherwise would be payable to subordinate creditors, then the so-called "rule of explicitness" is complied with, the language will be enforced and the senior creditor can receive payments of post-petition interest. However, the recently decided Bank of New England19 bankruptcy case appears to have nullified, at least in the First Circuit, the rule of explicitness and disturbed the established landscape in the name of overriding bankruptcy policy against bankruptcy-specific state law.20 In the December/January 2005 issue of the ABI Journal, Rick Mikels, in his article "Subordination Case Highlights Conflicts with State Law," discussed the Bank of New England case in detail and focused on the conflict-of-law issues raised by the case.21 In the court's opinion, while subordination agreements are uniformly acknowledged pursuant to §510(a) of the Bankruptcy Code, proper implementation of such a subordination agreement among unsecured creditors with respect to distributions from a bankruptcy estate is inevitably obscured by the principle of both English and American bankruptcy law disallowing post-petition interest on unsecured claims.22 Accordingly, the issue was reduced to whether it is ever possible to allow the payment of post-petition interest on an unsecured claim when there is a clear provision of the federal Bankruptcy Code that prohibits such payment. The First Circuit concluded that the only New York state law that could legitimately be incorporated by §510(a) is bankruptcy-neutral state law.
In a majority of the cases, the borrower/debtor is so highly leveraged, there is no ability to wage a successful priming fight, and pre-petition lenders are the only game in town.
According to the First Circuit, then, express adoption of the rule of explicitness by the New York Court of Appeals in Southeast Banking was essentially irrelevant because that court was fashioning an invalid bankruptcy-specific rule. Having thus invalidated the New York Court of Appeals's adoption of the rule of explicitness, the First Circuit considered the senior debt's entitlement to post-petition interest pursuant to the terms of a subordination agreement, construed in accordance with generally applicable, bankruptcy-neutral principles of contract law. The court concluded that the language of the subordination agreement was ambiguous as applied to the issue of post-petition interest and therefore remanded "for fact-finding on the parties' intent vis-à-vis post-petition interest."23
Clearly, the issues surrounding the validity of the rule of explicitness and, if valid, what needs to be placed in an intercreditor agreement that will provide for post-interest to be paid to senior creditors either in accordance with the rule of explicitness or some other "generally applicable, bankruptcy neutral principle of contract law" are far from resolved. Additionally, the Bank of New England case gets further complicated, and perhaps the post-petition interest issue lost, as it slips into a dark tunnel of controversy concerning conflict-of-law provisions and the intersection of federal bankruptcy policy and state law.
DIP/Cash Collateral Issues
Recently, in a case in the Middle District of Pennsylvania, New World Pasta,24 objections were filed by junior lien-holders to the motions requesting approval of the debtor-in-possession (DIP) financing facility, cash collateral and adequate protection (the "objections"). In the objections, the junior lien-holders acknowledged that the debtor needed the post-petition financing on a super-priority basis, but requested that the court strike certain provisions as "offending language" since, in the objecting creditors' opinion, the "offending language" "potentially deprives the pre-petition junior lenders of fundamental bankruptcy rights and protections that cannot be traded away in pre-petition agreements to the extent that [such agreements] purport to do so."25 The "offending language" specifically sought a waiver from the pre-petition junior lenders of the rights to adequate protection and to vote on the chapter 11 plan. The objection acknowledged the cases cited in this article and argued that any order approving the DIP financing and authorizing cash collateral should not be used to obtain declaratory or injunctive relief on these unsettled issues of the enforceability of waiver provisions by junior lien-holders in bankruptcy cases. The objection further argued that the enforceability of the "offending language" can only be properly decided as part of an adversary proceeding.
The New World court ultimately issued a final order approving the DIP facility, cash collateral and granting adequate protection (the "order").26 The order specifically approved the subordination of payment of the junior creditors to the senior creditors.27 However, the final order did tone down the "offending language" and replaced it with very general language that reserved the rights of all.
There is no reported decision that explains the basis for the court's order for the original "offending language" to be revised in a way that clearly reserves any disputes concerning the enforceability of the waiver provisions in the subordination agreement for another day. However, counsel involved in the dispute have shared that the objections were resolved consensually. Specifically, the "offending language" and any appearance of approval of the underlying waivers or injunctive or declaratory relief was removed and replaced with reservations of rights by all. In other words, the fight was reserved for a later day.
While the New World Pasta case ultimately does not provide clear answers to the question of enforceability of the types of waivers typically found in silent second liens, it is instructive in many ways. First, the final order was issued in July 2004 and confirms that there are no clear answers to the question at hand. Second, the objection suggests that approval of DIP financing, cash collateral and adequate protection in bankruptcy cases involving pre-petition facilities that involved second liens may be construed as a blessing of the underlying loan documents and the waivers they contain. The ultimate change in the language seems to imply that such a conclusion is possible and could act as an injunction against raising the issues later. Finally, the New World Pasta case also shows that the issues may not be resolved once and for all in a reported decision because many cases that involve the issues of enforceability of the silent second lien will ultimately be settled either on their own or as part of a greater settlement. Once a bankruptcy case is filed, time is short. DIP facilities and cash collateral need to be in place essentially before the case is filed. In a majority of the cases, the borrower/debtor is so highly leveraged, there is no ability to wage a successful priming fight, and pre-petition lenders are the only game in town. Issues need to be resolved quickly, and no one benefits, not the least of which the junior lenders, if precious time is lost and enormous amounts of the debtor/borrower's money is spent on litigating these issues. Settlement is in everyone's best interest. An area where it may be worthwhile to litigate the waivers may be at plan confirmation time and the enforcement of voting waivers. However, it is likely that by the time of plan confirmation, most of the issues will have also been consensually resolved by the parties over the course of the case.
Practical Suggestions to Address Enforceability Concerns
The cases examined herein establish that bankruptcy courts definitely acknowledge and will enforce subordination agreements pursuant to §510 of the Bankruptcy Code. However, practitioners need to be aware that the clear enforcement of subordination provisions will be with respect to payment and priority of payment only. When it comes to the enforcement of waivers of voting rights and the ability to file a proof of claim, receive adequate protection and other similar waivers and restrictions on the rights of junior lenders, courts have issued differing opinions. The following suggestions are a few that may help in receiving a finding from a bankruptcy court enforcing certain waiver provisions.
As to the payment of post-petition interest, senior creditors would be wise to carefully craft language that is "precise, explicit and unambiguous," making it clear to junior noteholders that their payment of the senior creditors' interest may entitle the senior creditors to receive more in a bankruptcy case than the Code will allow. Even if the rule of explicitness is not recognized by a court, if the language is sufficient to create a right to receive the payment under bankruptcy-neutral applicable state contract law, then the standard may be met. However, the suggestion from the Bank of New England court that the language must meet bankruptcy-neutral applicable state law provides nothing more than a murky standard for which no clear direction has been established. Frankly, if a court in the First Circuit, or other court deciding to adopt the Bank of New England rationale, accepts that because the rule of explicitness conflicts with a bankruptcy policy against the payment of post-petition interest to a senior lender when it would not have been entitled to receive it from the debtors, it is hard to imagine how any language could clear the established bar. For now, anyway, in the First Circuit, lenders have much to be concerned about, although clear language indicating intent of the parties with respect to the payment of post-petition interest would be helpful. In all other circuits, until decisions are issued, lenders should continue to be as precise as possible in all language concerning the payment of post-petition interest and the circumstances of the payment, and explain exactly what the junior lien-holder is agreeing to in the intercreditor agreement. Additionally, any language clearly spelling out the intent of the parties with respect to the payment of post-petition interest could also be helpful.
As to voting waivers, the LaSalle court and others make it clear that, in their opinion, §1126 rights under the Bankruptcy Code cannot be contracted away. However, the Davis and Urban Broadcasting courts seem to recognize the sophistication of the parties and the enforceability of waivers of voting rights. One possible way to address the decision in LaSalle is to make sure that the provisions in the intercreditor agreement concerning voting are sufficient to create an agency relationship between the junior and senior secured lenders rather than a transfer waiver of voting rights.28 If the senior lender is an agent to vote the claim of the junior lender, then the issue of altering §1126 rights might not be an issue. Additionally, Federal Rule of Bankruptcy Procedure 3018(c) specifically provides that any acceptance or rejection of a chapter 11 plan must be by "the creditor...or authorized agent." A note of caution is warranted, however; the LaSalle court specifically discussed the application of Rule 3018(c) and concluded that because an "agent" is understood to act at the direction of the principal, and because in the LaSalle case the senior creditor would be acting in its own interest, the senior creditor could not vote the junior creditor's claim as its agent. The question is left open, however, if a different result is warranted when a direct agency relationship is established rather than seeking a determination by the court that an agency relationship is created based on conduct.
As to waivers not involving voting rights, given the implication of the New World Pasta case, careful attention should be paid at the time of the approval of DIP financing, cash collateral and adequate protection. Depending on which constituency counsel is advocating for, objections and global reservations of rights (similar to those in the New World Pasta final order) may be appropriate. The negotiation of whether to include reservations of rights may bring issues to the surface that can precipitate in settlement. At the very least, the reservation of rights can prevent an argument at a later point in the case that any objections have been waived, and the inference of approval of the first-day orders is that the bankruptcy court has approved the post-petition enforcement of all the waivers and rights in the pre-petition loan documentation.
1 Ms. Brighton is special counsel with Kennedy Covington Lobdell & Hickman in Charlotte, N.C., in the Financial Services Department - Financial Restructuring Group, where she practices primarily in the area of bankruptcy, workouts and secured lending. She is a contributing editor for the ABI Journal and serves on its Editorial Board, as well as on the Advisory Board for the ABI Law Review. She is certified in Business Bankruptcy by the American Board of Certification and is a frequent author and lecturer on bankruptcy-related topics. Return to article
22 See Nicholas v. United States, 384 U.S. 678, 86 S.Ct. 1674, 16 L.Ed. 2d 853, 66-1 U.S. Tax Cas. (CCH) ¶9465, 17 A.F.T.R. 2d 1194 (1966); City of New York v. Saper, 336 U.S. 328, 69 S.Ct. 554, 93 L.Ed. 710, 49-1 U.S. Tax Cas. (CCH) ¶9198, 38 A.F.T.R. (P-H) ¶491 (1949); Sexton v. Dreyfus, 219 U.S. 339, 31 S.Ct. 256, 55 L.Ed. 244 (1911) Norton Bankr. L. & Prac. 2d §42:19; Bankr. Serv., L. Ed. §§23:106, 24:25, 25:38. Return to article
26 In re New World Pasta, M.D. Pa. Case No. 04-02817, Final Order Authorizing (A) Secured Post-petition Financing on a Super Priority Basis Pursuant to 11 U.S.C. §364, (B) Use of Cash Collateral Pursuant to 11 U.S.C. §363 and (C) Grant of Adequate Protection Pursuant to 11 U.S.C. §§363 and 364, entered July 9, 2004. Return to article