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In a decision that provides lessons for senior and junior secured lenders alike, a bankruptcy court recently upheld the enforceability of a provision in a subordination agreement allowing a senior secured lender to vote a junior secured lender's claim in bankruptcy without regard to the junior lender's wishes.

Background

The recent proliferation of second lien financings and real estate loan transactions involving multiple mortgagees has produced subordination and other intercreditor agreements in which junior secured lenders typically make various concessions in favor of senior secured lenders. Senior lenders want to ensure that their rights and remedies are as free as possible from interference by the subordinated lender, while subordinated lenders seek to limit the senior lender's control. Senior lenders have insisted that subordinated lenders agree that, should the borrower propose a plan of reorganization in a bankruptcy proceeding, the senior lenders would have the right to vote the subordinated lenders' claim. While such provisions may have become less common due to increased bargaining power of junior lenders, the question of whether they are actually enforceable remains the subject of much debate. Unfortunately, there is very little case law addressing the question. Accordingly, a recent decision by an Atlanta bankruptcy judge squarely tackling this hot topic is noteworthy.

The Facts

When the debtor obtained a loan from a bank (the "Senior Lender"), the debtor and its original secured lender (the "Junior Lender") signed a subordination agreement pursuant to which the claims and liens of the Junior Lender against the debtor were subordinated in all respects to the claims and liens of the Senior Lender. The subordination agreement also affected various substantive rights otherwise held by the Junior Lender, and even permitted the Senior Lender to take certain actions in the name of the Junior Lender, to the Junior Lender's detriment. In particular, the Junior Lender agreed that the Senior Lender would have the right to vote the claims held by the Junior Lender in any bankruptcy proceeding of the debtor.

In 2006, the debtor commenced its Chapter 11 case in the Atlanta bankruptcy court. The Senior Lender filed a ballot voting, on behalf of the Junior Lender, to accept the debtor's proposed plan of reorganization, but the Junior Lender filed its own ballot rejecting the plan. The Junior Lender also filed a motion asking the court to declare that the Senior Lender could not enforce the provision in the subordination agreement that authorized it to vote the Junior Lender's claim, and that the Junior Lender held the right to vote its claim.

The Junior Lender's Argument

In support of its motion, the Junior Lender relied heavily upon a decision issued by a Chicago bankruptcy court in 2000 which declared a similar provision in a subordination agreement to be unenforceable. The Chicago judge had reasoned as follows: (1) pre-petition agreements cannot override contrary provisions of the Bankruptcy Code, which provides that the holder of the claim is to vote to accept or reject a bankruptcy plan; (2) while the Bankruptcy Code permits the enforcement of subordination agreements, subordination, by definition, affects the order of priority of payment of claims, but not the transfer of voting rights; and (3) the Federal Rules of Bankruptcy Procedure require that a vote on a bankruptcy plan be signed by the creditor or its authorized agent, which would, in that court's view, exclude a party who is acting in its own interests to the detriment of the holder of the claim.

The Holding

Disagreeing with the Chicago court, the Atlanta bankruptcy judge denied the motion and upheld the right of the Senior Lender to vote the Junior Lender's claim. The court determined that:

• The subordination agreement was enforceable under applicable non-bankruptcy law, and held that it should be enforceable according to its terms;
  
  

• Nothing in the Bankruptcy Code expressly or implicitly prevents a delegation or bargaining away of the right to vote on a bankruptcy plan; and
  
  

• The Senior Lender was, a matter of law, acting as the duly authorized agent of the Junior Lender, even though it was not acting in the interests of the Junior Lender.

Addressing the Chicago court's presumption that an agent is one who acts at the direction, and in the interests, of its principal, the court noted that the situation before it was similar to that of a real estate lender who could, under Georgia law, execute a deed as agent for a borrower under a power of sale to convey title to a property in a foreclosure sale—even though the lender (agent) is acting to the detriment of the borrower (principal). The court also observed that the Junior Lender had the right to free itself from the ongoing effect of the subordination agreement by paying the Senior Lender's claim in full in cash.

Conclusion

Which of these conflicting results will become the prevailing trend is of course uncertain. Here, the debtor's opposition to the Junior Lender's motion may have affected the bankruptcy court's decision. The argument that an agreement reached in good faith in an arms-length negotiation between sophisticated lenders should be enforced is compelling. A senior lender hoping to enforce such an agreement should be sure to clarify in its subordination agreement that the parties intend to create an agency relationship between the senior and the junior lender. Alternatively, if it has sufficient negotiating leverage, a senior lender may want to insist that the junior lender agree to assign its claim to the senior lender if the borrower files for bankruptcy, because it is generally accepted that an assignee of a claim has the right to vote that claim.

For further information regarding these or other lending issues, you may contact Paul Rubin at 212-592-1448 or prubin@herrick.com

Herrick's Financial Restructuring, Bankruptcy and Creditors' Rights Practice Group represents debtors, creditors' committees, secured and unsecured creditors, trustees, financial institutions, investment banks, asset-based lenders, insurance companies, pension funds, purchasers of assets, landlords, acquirers 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 2007 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.