Disputes regarding the application of subordination provisions are proliferating. At issue in a recent Delaware bankruptcy case was the interpretation of a particular "X-Clause." An X-Clause is an exception to the general subordination scheme. It allows junior noteholders to retain existing equity interests or obtain new equity interests pursuant to a plan of reorganization under which senior noteholders are either being paid in full or receiving securities that are senior to those received by junior noteholders. The lesson of this decision is that holders of subordinated notes cannot rely on what may appear to be the plain language set forth in an X-Clause to avoid subordination in the event of a bankruptcy.
The Case: The court dismissed a lawsuit brought by holders of subordinated notes who sought a declaration that the debtor's proposed plan violated applicable law by failing to: (i) provide for distributions of new common stock to them; and (ii) allow them to participate in a rights offering for new common stock. The plan provided for issuance of new common stock to senior noteholders, but did not provide for any distribution to junior noteholders. The language of the X-Clause in question appeared to provide that the junior noteholders could receive new stock even if senior noteholders were not being paid in full. But the bankruptcy court found that exceptions to subordination, such as X-Clauses, should be read narrowly and must be interpreted in harmony with the broader context of the subordination agreement. Accordingly, the subordinated noteholders were not entitled to any distribution under the plan because senior noteholders were not being paid in full.
The X-Clause in question: The subordinated note indenture at issue provided for the following upon a distribution to creditors in a bankruptcy:
(i) holders of Senior Debt shall be entitled to receive payment in full of all Obligations due in respect of such Senior Debt … before Holders of the Notes shall be entitled to receive any payment with respect to the Notes (except that Holders may receive (i) Permitted Junior Securities …); and
(ii) until all Obligations with respect to Senior Debt (as provided in subsection (i) above) are paid in full, any distribution to which Holders would be entitled but for this Article shall be made to the holders of Senior Debt (except that Holders of Notes may receive (i) Permitted Junior Securities …) (emphasis added)
Under the indenture, the term "Permitted Junior Securities" was defined as:
(1) Equity Interests in the Company, …; or
(2) debt securities that are subordinated to all Senior Debt and any debt securities issued in exchange for Senior Debt to substantially the same extent as, or to a greater extent than, the Notes and the Guaranties are subordinated to Senior Debt under this Indenture.
The Argument: The subordinated noteholders advanced a fair reading of the subordination agreement, arguing that the term "Equity Interests" set forth in clause (1) of the definition of Permitted Junior Securities was not modified by the language applicable to "debt securities" in clause (2). Thus, they argued that the indenture excepted the issuance of "Equity Interests" (as "Permitted Junior Securities") under a chapter 11 plan from the general subordination of their interests to those of senior noteholders. They also claimed that where a chapter 11 plan contemplates distributions of "Equity Interests," subordinated noteholders must share in the distributions pari passu, regardless of whether senior noteholders were to be paid in full.
The Holding: The bankruptcy court disregarded the plain language of the X-Clause, concluding that the clause "must not be considered based upon its grammatical structure alone, but also within the context of the entire agreement." Finding that the purpose of X-Clauses generally is to allow subordinated noteholders to retain their interests only if securities given to senior noteholders have a higher priority to future distributions and dividends, the court ruled that exceptions to the overall subordination scheme must be read narrowly. Therefore, it held that the subordination language contained in clause (2) applicable to "debt securities" should also apply to "Equity Interests" in clause (1), so that the issuance of "Equity Interests" was not excepted from the overall subordination arrangement. Consequently, the court ruled that the subordinated noteholders were not entitled to receive any stock under the plan since senior noteholders were not being paid in full.
Conclusion: Junior creditors must beware that a court may choose to analyze an X-Clause in the context of the overall subordination agreement without confining itself to grammatical structure alone. Subordination agreements are designed to protect senior creditors, and X-Clauses are interpreted narrowly in order to protect the rights of such creditors.
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Herrick's Financial Restructuring, Bankruptcy and Creditors' Rights Practice Group represents debtors, creditors' committees, secured and unsecured creditors, trustees, financial institutions, hedge funds, investment banks, asset-based lenders, insurance companies, pension funds, purchasers of assets, landlords, acquirors of distressed debt, equipment lessors and licensors in workout, restructuring, bankruptcy, and reorganization matters. Our clients range from Fortune 500 corporations to small public and private companies.
Copyright 2008 Herrick, Feinstein LLP. The Lending and Restructuring Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.