The Ingenuity of Subordinated Debt

The Ingenuity of Subordinated Debt

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Subordinated debt is the unwanted relative of unsecured creditors. It must be as resourceful, loud, threatening and as creative as Mordred in the court of King Arthur to effect a meaningful recovery in a field of senior creditors. Two recent decisions add ingenious arguments to the arsenal of counsel who represent this humble class of claims in the bankruptcy process.

"Claim Preclusion"1

In CoreStates Bank NA v. Huls America Inc., 176 F.3d 187 (3rd Cir. 1999), the Third Circuit Court of Appeals held that failure to litigate the issue of priority pursuant to a subordination agreement in conjunction with its objection to confirmation of a chapter 11 plan precluded subsequent litigation to determine rights of creditors relative to each other pursuant to a subordination agreement. CoreStates Bank and Huls America had lent substantial sums to United Chemical Technologies Inc. (UCT) to enable UCT to purchase a manufacturing facility from Huls. Huls had agreed in the subordination agreement that it would not retain any payment by UCT until CoreStates was paid in full, even if UCT went into bankruptcy. When UCT filed for bankruptcy, it made a substantial payment to Huls before the confirmation of a plan. CoreStates objected to the plan on many grounds, including that the payment to Huls constituted unfair discrimination, though the objection did not rely upon the subordination agreement itself.

CoreStates later brought suit in the district court to establish its priority over Huls pursuant to the subordination agreement. UCT was not a party. The Third Circuit panel, by Chief Judge Edward R. Becker, affirmed the district court in holding that CoreStates had had its day in court and that it should have raised the issue of the subordination agreement at the time it objected to the plan.2

Judge Walter K. Stapleton wrote a scathing dissent. 176 F.3d 187, 207. He charged that the majority had "ignored" well-established principles of claim preclusion to create an "'entire controversy doctrine' for bankruptcy litigation" and concluded: "Because the parameters of this new doctrine are so broad and ill-defined, I fear that much mischief will be done by today's decision." Id.

...these cases underscore that often the best approach is to await a strategic advantage presented by the posture of the case or poorly drafted documents...

"Rule of Explicitness"

The Eleventh Circuit Court of Appeals recently affirmed a ruling denying a request for post-petition interest by an indenture trustee of senior notes pursuant to a subordination agreement. In re Southeast Banking Corp., 179 F.3d 1307 (11th Cir. 1999). The court noted that the parties agreed the subordination agreement provided that the senior notes were to be paid "in full" before junior notes were to be paid anything.

Because the Bankruptcy Code requires enforcement of subordination agreements "to the same extent that such agreement is enforceable under applicable non-bankruptcy law," 11 U.S.C. §510(a), it would appear that the senior notes should be paid interest before the subordinated notes are paid.

The court's analysis in denying the interest was a multi-step process: First there was a recognition that interest is generally not available to unsecured creditors in an insolvent estate. 11 U.S.C. §502. None of the notes were secured and therefore none were entitled to interest under 11 U.S.C. §506(b). Second, the language of §510(a), which requires an examination of non-bankruptcy law, led the court to the State of New York and an examination of New York's interpretation of an equitable principle called the "rule of explicitness."

The "rule of explicitness" is described in Southeast Banking as federal common law that seeks to protect junior noteholders from the seemingly inequitable result of allowing senior noteholders more than they would be allowed in a bankruptcy, at the expense of the junior noteholders who presumably might not have thought about this result at the time of the execution of the subordination agreement. The "rule of explicitness" requires that in order to enforce a subordination agreement requiring junior noteholders to pay senior noteholders interest upon a default, there must be language that is "precise, explicit and unambiguous." 179 F.3d at 1309.

But what language satisfies the rule? In an attempt to reconcile the "rule of explicitness" with the §510(a) requirement of enforcing the subordination agreement "according to non-bankruptcy law," the Eleventh Circuit certified the question of appropriate language to the New York Court of Appeals. See Chemical Bank. v. First Trust of New York, 93 N.Y. 2d 178, 710 N.E. 2d 1083 (1999). The result was incorporated into the Southeast Banking case: "New York law would require specific language in a subordination agreement to alert a junior creditor to its assumption of the risk and burden of allowing the payment of a senior creditor's post-petition interest demand." 179 F.3d 1307, 1310.

The Eleventh Circuit took this direction and compared the language in the subordination agreement (requiring that the senior notes were to be paid "in full," before junior noteholders were to receive any payment) to the test provided by the New York Court of Appeals, and found that it failed to be insufficiently precise, explicit and unambiguous.

While the holder or attorney for subordinated debt is often left with few rights and recoveries in reorganization proceedings, these cases underscore that often the best approach is to await a strategic advantage presented by the posture of the case or poorly drafted documents, rather than the loud, threatening leverage tactics employed by junior holders. These cases are required reading for representatives of the anxious subordinated debt and warnings to unwary senior debt.


1 The CoreStates court started with a general test for claim preclusion: "(1) a final judgment on the merits in a prior suit involving (2) the same parties or their privities and (3) a subsequent suit based on the same cause of action as a bar from litigating a claim that it could have raised in a prior proceeding." 176 F. 3d 187, 194, citing Board of Trustees of Trucking Employees Welfare Fund Inc. v. Centra, 983 F. 2d 495 (3rd Cir. 1992). The CoreStates court tuned the three-part test to one for bankruptcy cases: (1) the current claim would have been within the jurisdiction of the court hearing the prior bankruptcy proceeding, one that "could conceivably have an effect on the estate being administered in bankruptcy; "(2) generally, the party to be precluded had to have raised a claim; and (3) claim preclusion applies if the events underlying the current claim are essentially similar to those underlying the claim made in the bankruptcy proceeding." 176 F. 3d at 191 [citations omitted]. Return to article

2 The CoreStates opinion holds that claim preclusion issues in bankruptcy courts are not affected by whether the bankruptcy court is exercising core or non-core jurisdiction, and it notes that three other circuits are in accord. Robertson v. Isomedix Inc., (In re Intl. Nutronics Inc.), 28 F. 3d 965 (9th Cir. 1994); Sanders Confectionery Prods. Inc. v Heller Fin. Inc., 973 F. 2d 474, 482-83 (6th Cir. 1992); Sure-Snap Corp. v. State St. Bank & Trust Co., 948 F2d. 869 (2d Cir. 1991). Two circuits disagree and hold that the issue of core/non-core jurisdiction is relevant to the issue of whether a bankruptcy court order may have a preclusive effect. Barnett v. Stern, 909 F2d 973, 978-79 (7th Cir. 1990); Howell Hydrocarbons Inc. v. Adams, 897 F.2d 183, 189 (5th Cir. 1990). Return to article

Journal Date: 
Friday, October 1, 1999