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The Assignment of Voting Rights in Intercreditor Agreements: Enforceability and its Impact on Plan Confirmation

Editor's Note: The following article, "The Assignment of Voting Rights in Intercreditor Agreements: Enforceability and its Impact on Plan Confirmation," won the prize for second place in the Fourth Annual ABI Bankruptcy Law Student Writing Competition. The article discusses several issues that arise for first and second lien lenders, and also analyzes the enforceability of an assignment of voting rights provision. The author, Alexander J. Nicas, is a student at St. John's University School of Law. In addition to recognition and publication of his article in the Bankruptcy Reorganization Committee Newsletter, Mr. Nicas receives a cash award of $1250, sponsored by Jenner & Block LLP, and a one-year ABI membership.

Second lien financing, which typically includes an agreement to “share” collateral already encumbered by a first lien lender, came into great favor last decade.[2]  From 2000-2007, the dollar volume for second lien loans grew from $200 million to an astonishing $30 billion.[3] Before a first lien lender grants access to its collateral, first and second lien lenders will almost always enter into an intercreditor agreement defining their relative rights.[4]  Throughout the boom years, second lien lenders agreed to subordinate, waive, or assign virtually all their secured creditor rights to the first lien lender.[5]  This article analyzes whether an assignment of voting rights provision is enforceable notwithstanding section 1126 of the Bankruptcy Code, which delineates who can vote for a plan of reorganization. 

I. A Typical Intercreditor Agreement
The most common provision in an intercreditor agreement – the subordination clause[6] – grants the first lien lender priority over proceeds of the collateral shared with junior secured creditors.[7]  But, provisions beyond payment subordination became commonplace in second lien financing agreements over the last decade.  For example, second lien lenders agreed to “standstill” after funding, limiting their ability to foreclose on collateral, either under state law or in a bankruptcy proceeding.[8]  Second lien lenders routinely waived a host of other bankruptcy-specific rights in a standard intercreditor agreement, such as the right to: (i) demand adequate protection, (ii) oppose the use of cash collateral, (iii) object to debtor-in-possession financing that is supported by the first lien lender, and (iv) vote in a Chapter 11 plan of reorganization.[9]   

II. Interpreting Intercreditor Agreements in Bankruptcy
Nowhere in the Code is “intercreditor” or “intercreditor agreement” defined.  Section 510(a) of the Code, however, provides that “[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”  Thus, if a subordination agreement is valid under state law, it should also be enforceable in bankruptcy.  Notwithstanding this apparently clear language, bankruptcy courts have been inconsistent in deciding “whether ‘subordination’ . . . can mean more than priority in distribution and lien rights in a bankruptcy case and can include the prebankruptcy waiver of the right[s] conferred under the Bankruptcy Code.”[10]  First lien lenders often argue that § 510(a) supports the enforcement in a bankruptcy case of the terms of a bargained-for intercreditor agreement.  On the other hand, second lien lenders have tried to limit enforceability to the subordination clause itself (i.e. only the subordination of payment), arguing that pre-petition waivers of ancillary rights are unenforceable in bankruptcy.

III. Cases Holding That A Pre-Petition Assignment Of Voting Rights Is Unenforceable In Bankruptcy

a. In re SW Boston Hotel Venture, LLC[11]
The court in SW Boston Hotel held that an assignment of voting rights is not enforceable in bankruptcy because such agreement nullifies specific provisions of the Code.  The parties’ intercreditor agreement expressly assigned, from the second lien lender to the first lien lender, the right to vote on the borrower’s plan of reorganization in a future bankruptcy proceeding, and pursuant to this assignment, the first lien lender voted on behalf of the second lien lender.[12] 

In support of its holding, the court first analyzed In re 203 N. LaSalle St. Partnership,[13] which held that an assignment of voting rights provision was contrary to § 1126(a) because only the holder of a claim may accept or reject a plan.[14]  Next, the court relied upon In re Hart Ski Manufacturing Co.[15] for the proposition that Congress did not intend to permit creditors to alter substantive provisions of bankruptcy law.[16]  Finding this case law persuasive, the court held that the first lien lender wasn’t the holder of the claim, and therefore its vote on the plan on behalf of the second lien lender was invalid because the assignment of voting rights provision altered substantive rights provided by the Code.[17]

b. In re Croatan Surf Club, LLC[18]
The court in Croatan Surf Club addressed the same issue as was reached in SW Boston Hotel and came to the same conclusion: a first lien lender cannot vote a second lien lender’s claim, notwithstanding that the intercreditor agreement between the parties expressly assigned the right to vote.  Most importantly, the court illustrated why the assignment of voting rights provision was unenforceable by relying upon sections 1126(a) and 1129(b)(1) of the Code, and Bankruptcy Rule 3018(c)).

First, the court adopted the reasoning of 203 N. LaSalle and Hart Ski, finding that subordination merely provides a different order of payment, and does not override the plain language of § 1126(a).[19]  In support, the court looked to the value of the collateral and the second lien lender’s potential for receiving a distribution.[20]  Given that the second lien lender likely had a secured claim, and definitely had an unsecured claim, the court held that the second lien lender’s interest “should be protected through the right to vote its claim(s) and negotiate its treatment.”[21]  The court also relied upon the phrase “[n]otwithstanding section 510(a)” in § 1129(b)(1),[22] and held that the use of the word “notwithstanding” in the statute removed § 510(a) from the purview of § 1129.[23]  Therefore, the court held that it could “confirm a plan which disrupts bargained for priority, and thus is inconsistent with the terms of a subordination agreement, as long as it is fair and equitable and does not discriminate unfairly.”[24] 

Finally, the court examined Federal Rule of Bankruptcy Procedure 3018(c), which provides, in part: “[a]n acceptance or rejection shall be in writing . . . [and] signed by the creditor or equity security holder or an authorized agent.”[25]  The first lien lender argued that this rule allowed it to vote the second lien lender’s claim because it was the second lien lender’s agent pursuant to the agreement.[26]  The court rejected this view, holding that the first lien lender would not be acting at the direction of a principal, a necessary predicate to an agency relationship, but would be acting out of self-interest.[27] 

IV.   Cases Holding That A Pre-Petition Assignment Of Voting Rights Is Enforceable In Bankruptcy

a. Blue Ridge Investors II, LP v. Wachovia Bank (In re Aerosol Packaging, LLC)[28]
In Aerosol Packaging, the debtor supported the first lien lender’s attempt to vote the second lien lender’s claim because a substituted vote would allow the debtor’s plan of reorganization to be confirmed.[29]  In contrast to the approach taken in 203 N. LaSalle, the court found that § 1126(a) “grants the right to vote to a holder of a claim, but does not expressly or implicitly prevent that right from being delegated or bargained away by such holder.”[30] Furthermore, because the subordination agreement appeared to be enforceable under state law (as required by § 510(a)), and because Federal Rules of Bankruptcy Procedure 3018 and 9010[31] “explicitly permit agents and other representatives to take actions, including voting, on behalf of other parties,” the court concluded that the right to vote on the plan had been lawfully assigned to the first lien lender and should be enforced in the bankruptcy case.[32] 

b. Avondale Gateway Center Entitlement, LLC v. National Bank of Arizona[33]
In Avondale Gateway, unlike the cases discussed above, the second lien lender did not expressly assign its right to vote on a plan.  Instead, the court considered whether a subrogation clause authorized the first lien lender to vote on a plan on behalf of the second lien lender.[34]  The clause at issue stated that the second lien lender’s “claims” were subrogated until the senior debt had been paid in full.[35]  Utilizing this language, the first lien lender argued that the second lien lender’s right to vote is part of its “claim,” thus subrogation granted the first lien lender the right to vote on behalf of the second lien lender.[36]

After finding that the clause was valid under applicable non-bankruptcy law, the court determined that the right to vote on a plan “is a derivative right possessed by the holder of the claim.”[37]  Therefore, the second lien lender’s right to vote, flowing from its claim, could be assigned to the first lien lender.[38]  However, under applicable non-bankruptcy law, a subrogation agreement is not enforceable with respect to non-assignable rights.[39]  In other words, “if a bankruptcy creditor’s right to vote a reorganization plan were non-assignable, the Subrogation Clause would be unenforceable as to that right.”[40]  Relying upon Aerosol Packaging among other authority,[41] the court held that voting rights were in fact assignable.[42] 
 
V. Conclusion
 
If courts trend towards a broad construction of § 510(a), thereby enforcing the terms of intercreditor agreements, a second lien lender might be left without recourse to control the treatment of its interests in the bankruptcy case.[43]  Of course, first lien lenders argue that such a result is exactly that for which it bargained with the second lien lender.  However, cases such as Hart Ski and 203 N. LaSalle provide second lien lenders with support for retaining rights in bankruptcy proceedings that arguably were bargained away in the intercreditor agreement.  There are no reported circuit court decisions resolving the issue.

If a circuit court takes up the voting issue, there are two possible approaches.  First, pre-petition waivers of bankruptcy-specific rights are generally unenforceable,[44] and because § 1126(a) unambiguously defines who may vote a claim, this provision overrides any contractual agreement altering who may vote a claim.  Second, because Congress chose not to remove § 510(a) from the purview of § 1126(a), which it had done in two other Code provisions,[45] an agreement enforceable under § 510(a) can override the plan language of § 1126(a).  
The legislative history of section 510(a) provides some insight.  The Senate Report accompanying the 1978 Code provides:

A subordination agreement will not be enforced, however, in a reorganization case in which the class that is the beneficiary of the agreement has accepted, as specified in proposed 11 U.S.C. 1126, a plan that waives their rights under the agreement.  Otherwise, the agreement would prevent just what Chapter 11 contemplates: that seniors may give up rights to juniors in the interest of confirmation of a plan and rehabilitation of the debtor.[46]

Second lien lenders can argue that the first sentence of this legislative history supports their position and the holdings in 203 N. LaSalle and its progeny. 

 


1. Candidate for Juris Doctor, June 2012.

2. See Lisa Matalon et al., Overview of the U.S. Second-Lien Loan Market, Corporates/U.S. and Canada Special Report, Fitch Ratings (Feb. 6, 2006), for an overview of the development, participants, and risks of the second lien loan market.

3. See e.g., Committee on Commercial Finance, ABA Section of Business Law, Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force, 65 Bus. Law. 809, 810 (2010) (noting that the second quarter of 2007 topped out at over $15 billion in loan issuance) [hereinafter Task Force]; Latham & Watkins LLP, Everything You Always Wanted to Know About Second Lien Financing (May 19, 2004). See also Robert Polenberg, 4Q10 Second-Lien Lending Review, Standard & Poor’s (2011) (stating that, in 2008, 2009, and 2010, there were approximately $3 billion, $1.9 billion, and $4.8 billion, respectively, of new second lien debt issuance).

4. See Task Force, supra note 2.

5. See id

6. For purposes of this article, an intercreditor agreement will refer to the broad contractual agreement that defines all of the rights of first and second lien lenders.

7. See e.g., In re Bank of New England Corp. 364 F.3d 355, 361 (1st Cir. 2004) (stating that a subordination agreement “alters the normal priority of the junior creditor’s claim so that it becomes eligible to receive a distribution only after the claims of the senior creditor have been satisfied”).

8. In this situation, the first lien lender typically requires that the second lien lender waive its right to move for relief from the automatic stay.

9. See William L. Norton, The impact of second lien financings on DIP financing, 5 Norton Bankr. L. & Prac. 3d § 94:37 (2012).

10. See David S. Kupetz, Intercreditor Subordination Agreements and Voting Rights in Chapter 11, 2010 Ann. Surv. Bankr. L. 11 (2010). Other commentators have also recognized that “it can be difficult to predict with certainty whether a bankruptcy court will enforce the waiver or assignment of ancillary rights.”   See Mark N. Berman & David Lee, The Enforceability in Bankruptcy Proceedings of Waiver and Assignment of Rights Clauses Within Intercreditor or Subordination Agreements, 20 J. Bankr. L. & Prac. 6, Art. 1 (Nov. 2011).

11. In re SW Boston Hotel Venture, LLC, 460 B.R. 38, 52 (Bankr. D. Mass. 2011). 

12. Id. at 43, 47-48.

13. 256 B.R. 325 (Bankr. N.D. Ill. 2000)

14. SW Boston Hotel Venture, LLC, 460 B.R. at 52 (emphasis added).

15. 5 B.R. 734 (Bankr. D. Minn 1980). Hart Ski also stands for the proposition that the Code guarantees each secured creditor certain rights, and rights “not related to contract priority of distribution pursuant to § 510 cannot be affected by the actions of the parties prior to the commencement of a bankruptcy case when such rights did not even exist.” Id. at 736.

16. SW Boston Hotel Venture, LLC, 460 B.R. at 52. 

17. Id.

18. In re Croatan Surf Club, LLC, No. 11-00194-8-SWH, 2011 WL 5909199, at *1 (Bankr. E.D. N.C. Oct. 25, 2011).  The parties’ subordination agreement contained a provision stating that the senior secured lender was empowered to file claims and proofs of claims and to take such other action including, without limitation, the voting of subordinated debt.  Id.

19. See id. at *2.

20. See id. at *3 (citing In re 203 N. LaSalle St. P’Ship, 246 B.R. 325, 332 (Bankr. N.D. Ill. 2000), for the proposition that reasonable bankruptcy policy dictates that if the assets in a given estate are sufficient, a subordinated claim certainly has the potential for receiving a distribution, and Congress may well have determined to protect that potential by allowing the subordinated claim to be voted).

21. Id. at *3.

22. See generally 11 U.S.C. § 1129(b)(1) (allowing a debtor to “cram down” a plan of reorganization over the objection of an impaired class of creditors).

23. Croatan Surf Club, LLC, 2011 WL 5909199, at *2 (citing In re TCI 2 Holdings, LLC, 428 B.R. 117, 141 (Bankr. D. N.J. 2010)).

24. Id.  The court went on to find that just because a subordination agreement may “contractually arrange the respective priority of debts . . . it was not intended to give the parties carte blanche to override . . . the Bankruptcy Code.” Id.

25. Fed. R. Bankr. P. 3018(c).

26. Croatan Surf Club, LLC, 2011 WL 5909199, at *3.

27. Id.  Specifically, the court held that agency involves “the existence of the right to control the method or manner of accomplishing a task,” something absent in this case.  Therefore, the first lienholder could not be seen as the second lienholder’s agent for purposes of Rule 3018(c). Id.

28. 362 B.R. 43, 45-47 (Bankr. N.D. Ga. 2006).  The subordination agreement stated that the first lien lender had the “the right to vote the claims” of the second lien lender. 

29. Id. at 44-45. 

30. Id. at 47.

31. Fed. R. Bankr. P. 9010 (Representation and Appearances; Powers of Attorney).

32. Aerosol Packaging, 362 B.R. at 47.

33. See Avondale Gateway Center Entitlement, LLC v. Nat’l Bank of Arizona, No. CV10-1772-PHX-DGC, 02-09-BK-12153-CGC, 2011 WL 1376997, at *2 (D. Ariz. Apr. 12, 2011).

34. Avondale Gateway, 2011 WL 1376997, at *1. “[T]he Bankruptcy Court held that the subrogation clause in the Subordination Agreement authorized [the first lien lender] to vote on behalf of [the second lien lender], and struck [the second lien lender’s] ballot, and accepted [the first lien lender’s] ballot with two votes against the reorganization plan.” Id.  “The Bankruptcy Court did not reach the issue of whether the subordination clause also gives [the first lien lender] the right to vote on behalf of [the second lien lender].” Id. at *2 n.3.

35. Id. at *2.

36. Id.

37. Id. at *2-3.

38. Id. at *3.

39. See id. at *4.

40. Id.

41. See In re Inter Urban Broad. of Cincinnati, Inc., Civ. A. Nos. 94-2382, 94-2383, 1994 WL 646176, at *2 (E.D. La. Nov. 16, 1994) (affirming a bankruptcy court’s confirmation of a plan where the senior lender voted claims of the junior lender pursuant to an intercreditor agreement); In re Erickson Ret. Communities, LLC, 425 B.R. 309, 316 (N.D. Tex. 2010) (finding that a sophisticated commercial entity who knowingly waived many legal and statutory rights was bound to “standstill” under the subordination agreement, and therefore could not move for the appointment of an examiner).  See also In re Davis Broad. Inc., 169 B.R. 229 (Bankr. M.D. Ga. 1994), rev’d on other grounds, 176 B.R. 290 (M.D. Ga. 1994) (enforcing the provisions of an intercreditor agreement, including the senior lienholders right to vote the junior lienholder’s claim, after the debtor’s plan had already been confirmed); In re Curtis Center Limited P’ship, 192 B.R. 648 (Bankr. E.D. Pa. 1996) (finding that the terms of an unchallenged subordination agreement were fully enforceable in bankruptcy, therefore a senior creditor was allowed to vote the junior creditor’s claim).

42. Avondale Gateway, 2011 WL 1376997, at *4. 

43. Cf. In re TCI 2 Holdings LLC, 428 B.R. 117 (Bankr. D. N.J. 2010) (deciding that an intercreditor agreement did not bar the second lien lenders' plan of reorganization). 

44. See e.g., In re Cole, 226 B.R. 647, 651-52 n. 7 (B.A.P. 9th Cir. 1998), for discussion of numerous cases holding that a debtor cannot waive the rights bestowed upon it by the Bankruptcy Code.

45. See 11 U.S.C. § 1129(b)(1) (“[n]otwithstanding section 510(a)”); id. § 510(c) (“[n]otwithstanding subsections (a) and (b)“).

46. S. Rep. No. 95-989, at 74 (1978).   

 



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