When multiple lenders extend credit to the same borrower, the lenders frequently enter into inter-creditor or subordination agreements to set forth the priority of repayment rights against the borrower and its assets. The Bankruptcy Code provides for the enforcement of subordination agreements to the same extent they are enforceable under applicable nonbankruptcy law, including state law, which generally provides that in the absence of ambiguity, the terms of a contract are construed and enforced according to their plain meaning. Thus, contractual rights arising from a subordination agreement are enforced under state law if the terms are plain and unambiguous and do not otherwise contravene state law. Although the principle seems straightforward that a subordination agreement is enforced in a bankruptcy context if it is enforceable under state law, a bankruptcy court that ostensibly applied this principle in the case of 203 North LaSalle Street Partnership nonetheless made a determination that was not entirely predictable.
In LaSalle, the bankruptcy court ruled that the senior lender's deficiency claim (the portion of the mortgage debt in excess of the value of the mortgaged property) has priority status over the junior lender's claim because there was general and broad language in the agreements between the parties providing for subordination, and the Bankruptcy Code does not require any special degree of explicitness to accord senior status to a deficiency claim. The court concluded that this ruling enforced the subordination agreements to the same extent they were enforceable under state law, though the court acknowledged that under state law, as compared with the Bankruptcy Code, the senior lender's recovery would have been limited to the value of its collateral because the loan is nonrecourse. As to the senior lender's right to vote the junior claim - a right expressly provided for in the subordination agreements - the court declined to enforce that contractual right against the junior lender, notwithstanding the explicit language of the subordination agreements that provided for the transfer of the voting rights to the senior lender.
The Subordination Issues in LaSalle
The relevant facts of LaSalle were not in dispute. The debtor's senior bank lender held a nonrecourse loan secured by a first mortgage on the debtor's real property, the debtor's sole significant asset. The junior lender, the debtor's general partner, held a nonrecourse loan secured by a second mortgage on the same property. Before the debtor commenced its bankruptcy case, the lenders entered into an inter-creditor agreement and a consent and subordination agreement which provided that, upon the debtor's liquidation or bankruptcy, the bank would be paid in full before the junior lender would receive any payment on account of its junior claim. The agreements also provided that the bank would be entitled, in its discretion and in the name of the junior lender, to file a proof of claim, collect and receive all payments due the junior lender, and vote the junior claim in any liquidation or bankruptcy proceedings of the debtor.
After the debtor filed its revised chapter 11 plan, in anticipation of the confirmation process, the bank sought a judgment from the bankruptcy court declaring that its entire claim, including any deficiency claim, would be entitled to payment before the junior lender could receive any payment from the debtor, and that it could vote the junior claim. In response, the junior lender argued that the bank's senior secured claim entitled it to be paid first only to the extent of the value of the mortgaged collateral, but that any deficiency claim of the bank should be paid pro rata with the junior claim. The junior lender also asserted that it retained the right to vote its own claim.
The Deficiency Claim
The court acknowledged that under state law, a nonrecourse lender would not be entitled to any recovery against the debtor beyond the value of the collateral. However, the court disagreed with the junior lender's contention that the bank was not entitled to payment of the deficiency claim because that claim arose only in the debtor's bankruptcy case by operation of section 1111(b) of the Bankruptcy Code, which, with certain exceptions, transforms nonrecourse claims to recourse claims. The court reasoned that although the nonrecourse senior debt could not be recovered from the debtor outside of bankruptcy beyond the amount of the collateral, the debtor's liability under the senior mortgage note nevertheless included the full amount of the unpaid principal and interest. In the court's view, the broad language of the subordination agreements clearly and unambiguously gave senior status to the full amount of that liability.
The court also rejected the junior lender's additional contention that, even if the subordination agreements were intended to confer senior status upon the deficiency claim, the agreements were not enforceable because they lacked explicit language to that effect. The junior lender asserted that the application of the subordination agreements to a deficiency claim must be specific, as required by the Rule of Explicitness. That judicial doctrine prohibits the payment of postpetition interest to an unsecured senior creditor from funds that would otherwise go to a junior creditor unless the subordination agreement explicitly provides for payment of that interest. The court concluded that the Rule of Explicitness concerns only the payment of postpetition interest and was inapplicable to the dispute at issue. Moreover, the court distinguished the payment of postpetition interest to an unsecured creditor, which ordinarily is prohibited under the Bankruptcy Code, from payment of an unsecured deficiency claim, which is not prohibited by the Bankruptcy Code and, therefore, requires no explicit provision to give effect to a subordination provision and confer senior status on a deficiency claim.
Accordingly, even though the subordination agreement did not explicitly grant senior status to the bank's deficiency claim, the court held that the deficiency claim was entitled to senior status because:
- the agreement contained broad, general language that clearly conferred senior status on the bank's entire mortgage claim,
- the deficiency claim was simply a "part of the general class of liabilities" arising under the mortgage claim, and
- the Bankruptcy Code does not require any specific degree of explicitness to accord senior status to a deficiency claim.
Voting of the Junior Claim
Turning next to the dispute over voting rights, the court proclaimed that "[w]hile the language of the subordination agreement governs the outcome of the Bank's right to repayment of any deficiency claim, the language of the Bankruptcy Code governs the determination of voting rights." In support of its ruling, the court cited a provision of the Bankruptcy Code which states that the "holder of a claim . . . may vote to accept or reject a plan," and it noted the parties' acknowledgement that the junior lender was the "holder" of the subordinated claim. In effect, the court construed the Bankruptcy Code provision to mean that only the actual holder of the claim was entitled to vote the claim.
In further support of its ruling, the court determined that:
- it would defeat the Code's purpose if parties could override Code provisions by entering into prebankruptcy contractual agreements contrary to Code provisions;
- subordination affected only the payment priority scheme in bankruptcy, not the transfer of voting rights; and
- the Bankruptcy Rules require a ballot to be signed by the creditor or its authorized agent, but the bank could not be regarded as the junior lender's agent because the bank would vote on the plan according to its own interests rather than those of the junior lender.
The court also observed that if the debtor's estate has sufficient assets, the junior lender might receive a distribution on its claim that would entitle it to a role in the plan negotiation and confirmation process. That role "would be eliminated by enforcing contractual transfers of Chapter 11 voting rights." Accordingly, the court held that the junior lender would be entitled to vote its own claim, despite express language to the contrary contained in the subordination agreements.
The LaSalle decision serves as a warning to parties to subordination agreements that they should use the utmost care in including in the agreement all terms and conditions as to their relative priorities of repayment rights, including priorities and entitlements to postpetition interest and any deficiency claim in the event of a bankruptcy filing, as well as related voting rights.
In LaSalle, the parties provided for the senior lender's right to vote the subordinated claims, and it is surprising that the court upset that expectation. Although it is true that subordination of a claim, in and of itself, does not automatically transfer the voting rights of the subordinated creditor, a subordination agreement, like the one in LaSalle, may set forth additional rights and obligations of the parties, such as the transfer of voting rights. Unlike agreements that provide for the prebankruptcy waiver of the automatic stay or of the right to seek bankruptcy relief, the consensual transfer of voting rights does not appear to violate public policy, particularly where the agreement is between nondebtor third parties.
The court's proclamation that "the language of the Bankruptcy Code governs the determination of voting rights" invites scrutiny. Under the Bankruptcy Code, a court may invalidate an entity's vote that was not cast or procured in good faith, but nowhere does the Bankruptcy Code state or infer that a claim holder may not agree to contractually transfer or assign its claim and voting rights to another entity. Moreover, the Bankruptcy Rules evidence the fact that contractual transfers of claims and related voting rights are permissible, and the courts are to enter appropriate orders if disputes arise in connection with such transfers.
Indeed, in Curtis Center Limited Partnership, a bankruptcy court in Pennsylvania reached a contrary decision on the same issue. In that case, the senior and junior lender were parties to a subordination agreement. Hoping to obtain the junior lender's vote, the debtor proposed in its plan to partially satisfy the "underwater" junior claim with payments from nondebtor assets. The senior lender argued that the junior lender could not vote because its voting rights were transferred to the senior lender pursuant to a subordination agreement. The court ruled in favor of the senior lender based on the clear language of the agreement, the Bankruptcy Code's mandate to enforce subordination agreements that are enforceable under state law, and the absence of any argument to undercut the efficacy of the subordination agreement or the applicability of the Code provision requiring enforcement of valid subordination agreements.
The decision of a district court in New York also supports the concept that the junior lender in LaSalle was not entitled to voting rights. In In re Itemlab, Inc., the court ruled that if the senior creditor would recover only 25% of its claim under the plan and the junior creditor would receive nothing, the junior creditor was deemed to have made an equitable assignment of its claim to the senior creditor and thus was not entitled to vote on the plan, although the subordination agreement did not expressly provide for the assignment of voting rights. The Itemlab court reasoned that "the person entitled to collect the claim should be the person entitled to vote the claim; otherwise the result would be anomalous and would repose in the inferior creditor the power to use his vote to determine how the superior creditor shall collect a claim in which the inferior creditor no longer has an interest."
As aptly noted by the LaSalle court, a contractual transfer of voting rights should not be enforced when there is clear evidence that a debtor's estate has sufficient assets to fully satisfy the senior claim, and the junior lender may be entitled to receive some distribution under a plan. However, in LaSalle, no evidence was presented that the debtor's estate had sufficient assets to make a distribution to the junior lender. Nonetheless, the court held that the contractual transfer of voting rights was unenforceable as a violation of Bankruptcy Code principles. The court's decision is questionable because it abrogates bargained-for contractual rights between nondebtor parties despite the Bankruptcy Code's mandate that subordination agreements be enforceable under the Code to the same extent as under applicable nonbankruptcy law.
- Bank of America v. North LaSalle Street Ltd. Partnership (In re 203 North LaSalle Street Partnership), 246 B.R. 325 (Bankr. N.D. Ill. 2000).
- In re Curtis Center Ltd. Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996).
- In re Itemlab, Inc., 197 F. Supp. 194 (E.D.N.Y. 1961).