ENFORCEABILITY OF INTERCREDITOR AGREEMENTS

ENFORCEABILITY OF INTERCREDITOR AGREEMENTS By Ned W. Graber INTRODUCTION Intercreditor agreements specify lien priorities, priorities for distribution, rights of notice of default and cure, and rights to modify, extend, make additional advances and transfer loans among multiple lenders. Upon a default of the senior or subordinate loans, standstill requirements may limit for some period of time the rights of some lenders to receive payments and proceeds of shared collateral to allow other lenders to work out problems with the borrower or realize on shared collateral without interference from the stayed lenders. The subordinate lenders in the event of a debtor s bankruptcy often agree (i) not to challenge the validity and enforceability of the senior lender s security interest, (ii) that the senior lender is entitled to all collateral proceeds until payment in full of its claims and before the subordinate lender receives any proceeds, (iii) to limit the subordinate lender s ability to vote of a reorganization plan, and (iv) to abide by the senior lender s positions with respect to adequate protection and the use or sale of collateral. Subordinate lenders may waive ancillary bankruptcy rights that are nondistributive rights of a creditor in a bankruptcy such as the right to contest the priority, validity or perfection of the senior lender s lien, to propose or oppose debtor in possession financing, to consent to the debtor s use of cash collateral, to seek adequate protection, to seek relief from automatic stay, to seek an appointment of an examiner or dismissal of the case, to vote a claim, to propose or confirm a plan of reorganization, to object to a disclosure statement of a plan, and to consent or oppose a Section 363 sale. The presence or absence of these rights will determine whether the subordinate lender will be kept silent or have an active role in the bankruptcy. While early bankruptcy cases questioned the enforceability of the waiver in some of these ancillary rights, the trend of recent judicial reviews of intercreditor provisions is to recognize the enforceability of these provisions, except for waivers of voting rights that thwart bankruptcy public policy. ANALYSIS 1. Subordination Agreements and Bankruptcy Public Policy. Three principal questions determine whether an intercreditor provision will be recognized by a bankruptcy court: (i) whether the provision explicitly addresses the action that the senior creditor seeks to preclude, (ii) whether the action constitutes a bankruptcy public policy that should be protected, and (iii) whether the subordinate lender is an obstructionist in the bankruptcy case. Generally, judicial determination of the enforceability of a 1

subordinate lender s waiver or assignment of ancillary bankruptcy rights will begin with a recitation of Section 510(a) of the Bankruptcy Code of 1978 (the Code ), followed by a quick review of applicable state law to interpret the intercreditor provision and conclude with a consideration of bankruptcy public policy. 1 The results are not always consistent. A. Subordination Agreements Under Section 510(c) of the Code. Section 510(a) of the Code 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. 2 Hart Ski Manufacturing Co. 3 was the first case to construe an intercreditor agreement under this statute. The agreement expressly subordinated purchase money financing to a working capital loan. The subordinated lender, without the senior lender s consent, agreed not to assert collect, enforce or release...or realize any collateral securing the indebtedness or enforce any security agreements, real estate mortgages, lien instruments, or other encumberances [sic] securing said indebtedness except that it may collect regularly scheduled payments when and as due. 4 The subordinate lender also agreed to turn over to the senior lender any money received until the working capital loan was paid in full. No bankruptcy waivers were contained in the intercreditor agreement in the event of the borrower s insolvency. When Hart Ski filed for bankruptcy, the senior lender opposed the motion of the subordinate lender for adequate protection arguing that the intercreditor agreement prohibited payment of adequate protection to the subordinate lender until the working capital loan was paid in full. The Minnesota bankruptcy court stated that the intent of Section 510(a) is to allow the consensual and contractual priority of payment between creditors to be maintained among themselves in a bankruptcy proceeding. The court, however, rejected the senior lender s motion stating [t]here is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets. 5 Thus, the court would not enforce the intercreditor provision to deny the right to adequate protection in the absence of an express waiver. In addition, the court, without discussing any rationale, cast doubt on all waivers by stating that there are certain ancillary bankruptcy rights guaranteed to creditors by the Code, such as the right to assert and prove a claim, to seek ordered protection for its security, to have stay lifted and to file and vote on a plan of reorganization that cannot be affected by the actions of the 1 Mark N. Berman, David Lee, The Enforceability in Bankruptcy Proceedings of Waiver and Assignment of Rights Clauses Within Intercreditor or Subordination Agreements, 20 Norton J. Bankr. Law & Practice 779 (2011). 2 11 U.S.C.A. 510(a) which codified the pre-1978 Bankruptcy Act holding of In re Credit Industrial Corp., 366 F.2d 402 (2 nd Cir. 1966). 3 In re Hart Ski Manufacturing Co., Inc., 5 B.R. 734 (Bankr. D. Minn. 1980). 4 5 B.K. at 735. 5 5.B.K. at 736. 2

parties prior to the commencement of a bankruptcy case when such rights did not even exist. 6 The court, though, recognized the parties agreement by ruling that the receipt of adequate protection payments was governed by the intercreditor agreement and should be held in trust until the working capital loan was paid in full. Curtis Center Limited Partnership 7 involved the financing of a Philadelphia office building in which Mellon Bank agreed to subordinate its loan to working capital loan extended by Sumitomo Trust. The intercreditor agreement authorized Sumitomo to file all claims and vote or consent to any proceedings on behalf of Mellon as Sumitomo may in its sole discretion deem advisable. The debtor sought confirmation of its plan of reorganization with Mellon s approval over Sumitomo s objection. The Eastern District of Pennsylvania bankruptcy court found that the intercreditor agreement was unambiguous and fully enforceable in the debtor s bankruptcy and upheld Sumitomo s right to vote on behalf of the subordinate lender. 8 Because Sumitomo had declared that it would vote on Mellon s behalf to reject the plan, there was no hope that debtor could rely upon Mellon as an impaired class for purposes of confirmation of the cram down plan under Section 1129(a) of the Code. In 203 N. LaSalle Street Partnership, 9 the agreement subordinated the general partner s secured loan to Bank of America s secured loan and provided that in the event of any...bankruptcy, insolvency or receivership... [the general partner] irrevocably agrees that the [first lien holder] may, at its sole discretion... collect, receive... all such payments or distributions and vote or consent in any such proceedings with respect to, any claims of [the general partner]. 10 The first lien holder sought declaratory judgments that no payments should be made to the subordinate lender until both its secured and unsecured claims were paid, and that the bank could vote the general partner s claim in bankruptcy. The Northern District of Illinois bankruptcy court confirmed that the general partner s claim was subordinated to the bank s secured claim and non-recourse deficiency claim because both claims were included in the general subordination of all liabilities. The court, however, ruled that Section 510(a) of the Code does not allow for waiver of voting rights of holder of a claim to accept or reject a plan of reorganization under Section 1126(a) of the Code, nor does Section 1018(c) of the Bankruptcy Rules allow the bank to vote a subordinated creditor s claims. The court rejected the bank s argument that the 6 Id. 7 In re Curtis Center Ltd Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996). 8 The ruling is supported by two decisions involving broadcast companies, In re Inter Urban Broadcasting of Cincinnati, Inc., 1994 WL 646176 (Bankr. E. D. La. Nov. 16, 1994, dismissed 74 F.3d 1238 (5 th Cir. 1995) affirming a confirmation of plan where the senior creditor voted the claims of the junior creditor pursuant to an intercreditor agreement, and In re Davis Broadcasting, Inc., 169 B.R. 229 (Bankr. M.D. Ga.) rev d on other grounds, 176 B.R. 290 (M.D. Ga. 1994). 9 In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000). 10 246 B.R. at 327-28. 3

subordination agreement made the bank the agent of the general partner reasoning that the bank would be acting on its own behalf and not in the interest of the general partner. In Bank of New England, 11 the First Circuit considered a dispute over the distribution of post petition interest. The Chapter 7 trustee distributed liquidation proceeds to the senior lenders to pay in full the note and accrued interest to the date of bankruptcy filing, and filed a motion to seek guidance on the question whether to make a distribution to the subordinate lenders before paying post-petition interest to the senior lenders. The subordination provision required the payment of the senior debt in full before the subordinate lenders were entitled to any distributions. The bankruptcy court applying the Rule of Explicitness held that because the subordination provision did not refer to post-petition interest, 12 the trustee was not required to pay post-petition interest to the senior lenders prior to making distributions to the subordinate lenders. The First Circuit reversed on the grounds that the Rule of Explicitness did not survive the enactment of the Code in 1978, and stated under New York law that the bankruptcy court should determine the intent of the parties. The First Circuit stated that what equitable powers remain under the Bankruptcy courts must and can only be exercised within the confines of the bankruptcy court s equitable powers. 13 The problem with this approach is that looking solely to state law and applicable non-bankruptcy law for the enforceability of ancillary bankruptcy rights is fruitless. State courts do not address bankruptcy matters, and if they did their rulings would be superseded under the Supremacy Clause by the Code. This may be why when looking at nonbankruptcy law under Section 510(a), bankruptcy courts tend to use state contract rules for the interpretation of contract, and give very little effort to search for state authority that supports enforceability of the agreement or its ancillary rights. For example, in Aerosol Packaging, 14 the court simply stated that the subordinated creditor produced no evidence under Georgia law that the subordination agreement was unenforceable. Bankruptcy judges have to look elsewhere to determine the enforceability of waiver and assignment of ancillary bankruptcy rights. 11 In re Bank of New England Corp., 364 F.3d 355 (1 st Cir. 2004). 12 It is now common to include within the definition of Senior Debt the words and including interest, fees, cost, charges, expenses, and other amounts accruing or incurred during an Insolvency Proceeding whether or not such amounts are allowable in whole or in part in any such Insolvency Proceeding, Mark N. Berman and Jo Ann J. Brighton, Handbook on Second Lien Loans and Intercreditor Agreements, American Bankruptcy Institute p. 77-78 (2009). 13 364 F. 3d 335, at 362. 14 In re Aerosol Packaging, LLC, 362 B.R. 43 (Bankr. N.D. Ga. 2006); See also In Re Hinderler Industries, Inc., 228 B.R. (Bankr. E.D. Tex. 1999) and In Re General Homes Corp., 134 B.R. 853 (Bankr S.D. Tex. 1991). 4

B. Waiver of Voting Rights. The courts continue to be split on the issue of the enforceability of waivers of voting rights. In Aerosol Packaging, LLC, 15 the intercreditor agreement specifically authorized the senior lender to vote the junior creditor s claim in the borrower s bankruptcy, even if the vote was contrary to the junior creditor s interests. The Northern District of Georgia bankruptcy court held that nothing in Section 1126(a) of the Code expressly or implicitly prevents the junior creditor from delegating or assigning away its voting rights. The court analogized the assignment to a power of sale in a deed to secure debt authorizing the lender to act as agent of the borrower to convey title in a foreclosure. This decision is consistent with older decisions that uphold the transfer of voting rights to another creditor in a subordination agreement. 16 Claims in bankruptcy are freely assignable both before and after a case filing and all ancillary bankruptcy rights transfer with a complete assignment. Thus, if a creditor can assign all of its rights associated with a claim, it should also be able to waive or subordinate those rights pursuant to an intercreditor agreement. Other courts continue to rely upon the bankruptcy public policy to deny enforceability of waivers. Recently, the District of Massachusetts bankruptcy court in SW Boston Hotel 17 followed 203 La Salle and confirmed a debtor s plan of reorganization over the objection of the senior mortgage lender. Pursuant to the intercreditor agreement, the second mortgage lender had assigned its right to vote its claim in any debtor s bankruptcy to the senior mortgage lender. The debtor s amended plan of reorganization received approval of all of the creditors, except of the senior mortgage lender who also filed a ballot on behalf of the second mortgage lender. Upon the motion of the senior mortgage lender to strike a ballot filed by the second mortgage lender in favor of the proxy ballot, the court ruled that a subordination agreement cannot alter substantive rights under the Code and a creditor cannot waive or assign its right to vote for a plan of reorganization. C. Challenges to Liens. In Ion Media Networks, Inc., 18 the subordinate lender objected to the confirmation of a proposed plan that granted the senior lender value attributable to FCC licenses as part of the senior lender s collateral. The intercreditor agreement contained the following no contest clause: Each of the Secured Parties acknowledges and agrees (x) to the relative priorities as to the Collateral (and the application of the proceeds therefrom) as provided in the Security Agreement...and acknowledges and agrees that such priorities... shall 15 In re Aerosol Packaging, LLC, 362 B.R. 43 at 46 (Bankr. N.D. Ga. 2006). 16 In re Curtis Center Ltd Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996) enforcing an unchallenged subordination provision allowing the senior creditor to vote a junior creditor s claim; In re Inter Urban Broadcasting of Cincinnati, Inc., 1994 WL 646176 (E. D. La. Nov. 16, 1994, dismissed 74 F.3d 1238 (5 th Cir. 1995) affirming a confirmation of plan where the senior creditor voted the claims of the junior creditor pursuant to an intercreditor agreement. 17 In re SW SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr. D. Mass. 2011). 18 Ion Media Networks, Inc., 419 B.R. 585 (Bankr. S.D. N.Y 2009). 5

not be impaired in any manner whatsoever including, without limitation, on account of... any nonperfection of any lien purportedly securing any of the Secured Obligations... Upon the commencement of a case under the Bankruptcy Code by or against any Grantor...(b) each secured party agrees not to take any action or vote in any way inconsistent with this Agreement so as to contest (1) the validity or enforceability of any of the Security Documents... (2) the validity, priority, or enforceability of any of the Liens, mortgages, assignments, and security interests granted pursuant to the Security Documents... or (3) the relative rights and duties of the holders of the First Priority Secured Obligations... 19 In addition, the agreement provided that until the first lien holders were paid in full, the second lien holders may not oppose, object to or vote against any plan of reorganization or disclosure statement the terms of which are consistent with the rights of the First Priority Secured Parties under the Security Agreement. 20 The senior lender asserted that these provisions precluded the second lien holders from contesting the DIP financing, disclosure statement or confirmation of the reorganization plan. The second lien holders relied upon the reservation of rights in the intercreditor agreement that provided (e)xcept as otherwise specifically set forth in section 11 of this Agreement, the Second Priority Secured Parties may exercise rights and remedies as unsecured creditors against any Grantor in accordance with the terms of the Second Priority Documents and applicable law. 21 The Southern District of New York bankruptcy court held that the second lien holders were expressly prohibited from challenging the senior lender s lien and lacked standing to object to the plan. The judge distinguished Hart Ski, 203 North LaSalle, and Aerosol Packaging because those cases involved the right to vote on a plan. Obstructionist behavior by the subordinate lender also influenced the court. The court noted that the subordinate lender had purchased the second lien debt at a steep discount and had been using aggressive bankruptcy litigation tactics as a means to gain negotiating leverage. 22 In addition the subordinate lender was promoting an alternative plan to acquire the debtor s business. The court stated in its footnote 4 that the subordinate lender s violation of the intercreditor agreement exposes it to damages for breach of the contract measured by the material increase in administrative expenses in the case. 23 Centaur, LLC 24 involved the enforceability of intercreditor provisions that barred the second lien agent from opposing the entry of a cash collateral order approved by the 19 Id at 597 and 594. 20 Id. 21 Id at 598. 22 Id at 588. 23 Id at 590. 24 In re Centaur, LLC, et. al, Case No. 10-10799 (Bankr. D. Del. 2011). 6

first lien agent and from contesting the priority or validity of the first lenders liens. With respect to the cash collateral order, the Delaware bankruptcy court found that although there might be circumstances where intercreditor provisions should not be enforced because of bankruptcy imperative, these circumstances were not present in this case where the intercreditor agreement allowed the first lien agent to request adequate protection and the adequate protection was consistent with the intercreditor agreement. With respect to the lien challenge, the second lien agent argued that its actions were not a violation of the intercreditor agreement because it did not believe that the assets were collateral, and the agreement allowed the second lien agent, subject to certain limitations, to exercise its rights and remedies against the debtor as unsecured creditors. The judge disagreed and denied the second lien agent s discovery motion because it was a lien challenge and violated the intent and language of the intercreditor agreement. It should be noted, however, that an intercreditor provision prohibiting challenges to the perfection of a lien would not be binding upon a bankruptcy trustee. 25 2. Necessity of Explicit Drafting. Unclear drafting produces unpredictable outcomes. In Erickson Retirement Communities, LLC 26, the subordinate lenders filed a motion to appoint an examiner to determine the appropriateness and fairness of an allocation of value among the debtor s properties. The intercreditor agreement contained typical standstill provisions which generally prohibited the exercise or any rights or remedies or taking any action or proceeding to collect to enforce any of the Subordination Obligations 27 without the first lien lender consent until the first lien obligations had been paid in full. The second lien holders also waived any principles or provisions of law, statutory or otherwise, which are or might be in conflict with the terms of this Agreement and any legal or equitable discharge of the [subordinate lender s] obligations under the intercreditor agreement. 28 The Northern District of Texas bankruptcy court applied Maryland law that looks to what a reasonable person would have understood as to the meaning of the agreement. The court stated that sophisticated commercial entities had knowingly waived any conflicting legal statutory rights and constructively waived the right to seek an examiner. The subordinate lenders were prohibited from making the filing that the court described as tantamount to both a pursuit of a remedy and commencement of an action under the standstill provisions of the intercreditor agreements. 29 The court noted and was influenced by the obstructionist behavior of the second lien lenders. 25 In re Henzler Mfg. Corp., 36 B. R. 303 (Bankr. N.D. Ohio 1984). 26 Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D. Tex 2010). 27 Id at 314. 28 Id. 29 425 B.R. at 314. 7

The subordinate lenders in Boston Generating 30 objected to the bidding and auction procedures and later to a Section 363 sale pursuant to which there would have been no recovery for the subordinate lenders. The intercreditor agreement stated: Until the Discharge of First Lien Obligations has occurred, whether or not any Insolvency or Liquidation Proceeding has been commenced... the First Lien Collateral Agent, at the written direction of [First Lien Lenders holding a majority of the First Lien Debt], shall have the exclusive right to enforce rights, exercise remedies... and make determinations regarding the release, sale, disposition or restrictions with respect to the Collateral without any consultation with or the consent of the Second Lien Collateral Agent or any Second Lien Secured Party... provided that the Lien securing the Second Lien Obligations shall remain on the proceeds of such Collateral released or disposed of subject to the relative priorities. 31 (E)ach Second Lien Secured Party agrees not to take any action that would hinder any exercise of remedies under the First Lien Documents or is otherwise prohibited hereunder including any sale, lease, exchange, transfer or other disposition of the Collateral, whether by foreclosure or otherwise. 32 The provision did not define the term exercise of remedies. The subordinate lender had also reserved the right to vote on a plan of reorganization and any right and remedy available to unsecured creditors in a manner not inconsistent with the terms of the interceditor agreement. 33 The Southern District of New York bankruptcy court stated that the provisions were poorly drafted. It found that there was no express prohibition against objecting to the bidding procedures anywhere in the intercreditor agreement and allowed the objection, although it acknowledged that the action went against the spirit of the subordination scheme. When the court approved the bidding instructions, the subordinated lenders objected to the sale. The court allowed the objection. Noting that Section 6.2 of the ABA/First Lien/Second Lien Intercreditor Agreement Task Force Model Intercreditor Agreement 34 contains a provision expressly prohibiting subordinate lenders from contesting or objecting to a Section 363 sale of the collateral, the court stated that the senior lender must point to some similar provision that reflects an express or intentional waiver of rights, and found no such waiver in the intercreditor agreement. The court distinguished Ion Media because its intercreditor agreement contained an express waiver and its subordinate lender exhibited obstructionist behavior. The court in Boston Generating also stated that the proposed sale of substantially all of the assets 30 In re Boston Generating, 440 B.R. 302 (Bankr. S.D. N.Y. 2010). 31 440 B.R. at 316. 32 Id at 317-18. 33 Id at 317. 34 The Business Lawyer, Vol. 65, May 2010, pages 809-883. 8

outside of a plan of reorganization would deprive the subordinate lender of the opportunity to vote in any meaningful manner and the fact that the subordinated lenders were very close to the money and...want to make sure that the Debtors have discharged their fiduciary duty to get the highest price for their assets. 35 The court distinguished Erickson on the basis that its subordinate lender was an obstructionist without a realistic opportunity of recovery. It is important to note that the court in Boston Generating reached its decision by looking at the issue of enforceability not as an issue of standing but of waiver. Explicit drafting may have changed the result in Boston Generating. The different rulings between Erickson and Boston Generating may also be explained by a difference in state law rules of interpretation. The judge in Erickson applied Maryland law that asks what a reasonable person in the same position would have understood as the meaning of the agreement. 36 By contrast, the court in Boston Generating applied New York law that requires a restriction on the subordinated lenders to be express or intentional. This case demonstrates another reason to prefer explicit drafting over generalized provisions because many intercreditor agreements are governed by New York law. The advantages of explicit drafting are also illustrated in the Tousa case. 37 The second lien holders objected to the use of cash collateral to fund the investigation of liens and to pursue claims against the second lien holders pursuant to a cash collateral order negotiated between the debtor and the first lien holders. The intercreditor agreement provided: If a Credit Party becomes subject to any Insolvency Proceeding and if the First Priority Representative desires to consent (or not object) to the use of cash or other collateral under the Bankruptcy Code then the Second Priority Loan Agent agrees, on behalf of itself and the other Second Priority Secured Parties that each Second Priority Secure Party (I) will be deemed to have consented to the use of such cash or other collateral [and] will not request or accept any form of adequate protection or any other relief in connection with the use of such cash. 38 The Southern District of Florida bankruptcy court approved the cash collateral order and on appeal the district court affirmed stating that the second lien holders had clearly bargained away [their] right to object by entering into the Intercreditor Agreement. 39 35 440 B.R. at 320. 36 425 B.R. at 314. 37 Aurelius Capital Master, Ltd. v. Tousa, Inc., Nos. 08-61327-CIV, 08-61335, 2009 WL 6453077 (S.D. Fla. Feb. 6, 2009). 38 2009 WL 64530767 at 2. 39 Id at 5. 9

WestPoint Stevens 40 involved the same subordination clause interpreted in Boston Generating. Two groups of creditors sought to own controlling interest of the debtor. The debtor pursued a sale of its assets under Section 363 of the Code and when the second lien group controlled by Carl Icahn emerged with the winning bid a dispute arose regarding distributions. The first lien holders stipulated that the sale could proceed as long as the distribution was delayed until the dispute was settled. The district court reversed an order of the bankruptcy court distributing a controlling interest in the equity of the debtor to the second lien group on the grounds that the distribution violated an intercreditor agreement provision that the first lien holders be paid in full before the second lien holders received any distribution. The court ordered the equity allocated to the second lien holders to be given to the first lien holders. The second lien holders appealed. Based upon the stipulation for the sale made by the first lien holders, the Second Circuit court ruled that the issue of the enforceability of the subordination agreement was moot. The circuit court found that the control of the debtor was so integral to the sale that the bankruptcy court could not alter the terms of the distribution to the second lien group. The circuit court, however, in an action of equity ordered that an eleven percent interest in the debtor that left control of the debtor in the second lien holders be distributed to the first lien holders as a remedy for the erroneous ruling on priority rights. 3. Section 1129(b) Plans May Circumvent Intercreditor Provisions. Regardless of whether the stay silent provisions in intercreditor agreements are held enforceable in connection with a plan proposing a cram down of the first lender s claim, courts have proceeded to confirm plans over the objection of senior lenders. In TCI 2 Holdings, LLC 41 competing plans were presented for the Trump hotel casinos and the first lien lenders sought to disqualify the second lien lenders plan for a cram down of the first lien lenders debt under Section 1129(b)(A)(i) of the Code. The plan proposed by the first lien lenders would have converted the first lien debt into 100 percent of the equity of the debtor and wiped out the claims of the second lien lenders and unsecured creditors. The first lien holders argued that the intercreditor agreement required the first lien holders to be paid in full before the second lien holders were entitled to any distributions. The intercreditor agreement did not expressly prohibit the second lien holders from filing a competing plan of reorganization. The New Jersey bankruptcy court, however, did not reach its conclusion on the basis of public policy or the absence or enforceability of an express waiver. The court held that it did not need to determine whether the second lien holders had violated the intercreditor provision. Based upon a interpretation of Section 1129(b)(i) which states that 40 In re WestPoint Stevens, Inc., 600 F.3d 231 (2d Cir. 2010). 41 In re TCI 2 Holdings, LLC, 428 B.R. 117 (Bankr. D. N.J. 2010). 10

Notwithstanding section 510(a) of this title, if all of the applicable requirements of subsection (a) of this section other than paragraph (8) are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan, 42 the court stated that even though section 510(a) requires enforceability of the subordination agreement, the only logical reading of the introductory phrase notwithstanding section 510(a) of this title, in Section 1129(b)(i) is that the court shall confirm a plan which otherwise meets all the requirements of Section 1129(a) and (b). 43 Subsequently, the first lien holders sued the second lien holders for breach of contract and the litigation was ultimately settled. This holding contradicts an older case in which another court considering the same argument by the subordinate lien holder with similar facts reached the opposite conclusion that the subordination rights are enforceable despite the introductory phrase in Section 1129(b)(1) under the discrimination and fair and equitable concepts of the statute. 44 However, recently, in SW Boston Hotel 45 and in Croatan Surf Club, 46 two district bankruptcy courts relying upon public policy have ruled that a subordination agreement cannot alter substantive rights under the Code and a creditor cannot waive or assign its right to vote for a plan of reorganization. Both courts then confirmed the plans under the cram down requirements under Section 1129(a) of the Code. 4. Avoidance of Bankruptcy Imperatives. Three methods may avoid a decision that an intercreditor provision is unenforceability for bankruptcy public policy. A. Doctrine of Collective Action. Lenders often appoint an agent or trustee to act or forebear on their collective behalf with or without the consent of less than all of the lenders. Such actions may include consenting to the sale of collateral, creditbidding, and enforcing or forbearing remedies. In addition, individual lenders are prohibited from taking any independent enforcement action. Collective action agreements have been upheld to bar actions by individual creditors. The bankruptcy cases do not rely upon Section 510(a) of the Code because there is no subordination of 42 11 U.S.C.A. 1129(b)(1). 43 This reasoning was followed recently by the judge of In re Zais Inv. Grade Ltd. VII, 455 B.R. 839 at 849 (Bankr. D.N.J 2011) (on appeal). 44 In re Consul Restaurant Corp., 146 B.R. 979 at 988 (Bankr. D. Minn. 1992). See also In re Curtis Center Ltd Partnership, 192 B.R. 648 (Bankr. E.D. Pa. 1996). 45 SW Boston Hotel Venture, LLC, 2011 WL 5520928 (Bankr. D. Mass. Nov. 14, 2011). 46 In re Croatan Surf Club, LLC, 2011 WL 5909199 (Bankr. E.D.N.C. Oct. 25, 2011). 11

the claims. In Delphi Corp. 47 a dissenting group of post petition Tranche C lenders sought to prevent a majority of the Tranche A and Tranche C lenders from entering into an accommodation agreement granting forbearance to the debtors. The accommodation agreement had the effect of extending the maturity date of the financing by neutralizing the remedies during the forbearance period. The Tranche C lenders argued that any extension of the maturity date required unanimous consent under the credit agreement. The court held that two-thirds of the lenders could authorize the DIP agent to grant the forbearance, and that the Tranche C lenders could not enforce the debtors payment obligations after the maturity date. In Beal Savings Bank, 48 involving a syndicated loan for the Aladdin Resort and Casino in Las Vegas, the New York Court of Appeals held that a dissenting lender holding less than five percent of the applicable class claims could not take an independent enforcement action, contrary to the specific and unambiguous language that the lenders intended to act collectively. In Chrysler LLC, 49 the administrative agent had the exclusive right to direct the collateral trustee who had been granted the exclusive right to pursue all the lender s rights and remedies. The court held that the first lien holder of a one percent of the claims was bound to its agreement under the credit agreement that authorized the administrative agent of the first and second lien holders, at the request of a majority of the lenders, to consent to the sale of substantially all of Chrysler s assets. Finally, in Erickson, 50 the bankruptcy court held that even though all the requirements for a mandatory examination had been met under Section 1104(c) of the Code, it was not required to appoint an examiner at the request of the subordinate lien holders because they had waived their right to pursue remedies in favor of the syndicate s agent in a collective action agreement. It should be noted, however, that although there is strong case law supporting collective action, none of these cases was brought by the holder of a substantial portion of the minority interests. B. Subrogation. It has been suggested that an assignment of the rights of subrogation may overcome the bankruptcy public policy against waiver of the right to vote on bankruptcy claims. In Avondale 51, the court held that when the senior lender is subrogated in an intercreditor agreement to all of the subordinate lender s rights until the senior lender s debt is paid in full, the senior lender is deemed the holder of the subordinate lender s claim and can vote such claim. It should be noted, however, that although temporary assignment until the senior lender is paid may be recognized, it is unlikely that a bankruptcy court would uphold a complete elimination of voting rights of a subordinate lender. It would also be imprudent to make the subordination or 47 In re Delphi Corp., No. 05-44481 (Bankr. S.D. N.Y.). 48 Beal Sav. Bank v. Sommer, 8 N.Y.3d 318, 834 N.Y.S.2d 44, 865 N.E.2d 1210 (N.Y. Ct. App. 2007). 49 In re Chrysler LLC, 405 B.R. 84 (Bankr. S.D.N.Y 2009); See also In re Enron Corp., 302 B.R. 463 475 (Bankr. S.D. N.Y. 2003). 50 Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D. Tex 2010). 51 In re Avondale Gateway Center Entitlement, LLC, 2011 WL 1376997 (D. Ariz. 2011). 12

subrogation effective upon the default by the debtor, as it may be an impermissible ipso facto clause. Finally, if a court was inclined to use bankruptcy public policy to invalidate a waiver, it could certainly use the same reason to refuse to enforce an assignment of subrogation rights. C. CDO Agreements. Each lender to a borrower is considered to have made a loan to the debtor and has a claim against the bankrupt estate. This treatment supports the right of each lender to vote on the plan of reorganization and exercise other ancillary bankruptcy rights. One method to avoid claims by individual lenders against a bankruptcy estate is to use a collateral debt obligation structure pursuant to which each creditor holds an interest of particular priority in a special purpose entity that holds a claim against the debtor. The individual lenders in this structure are not a parties in interest under the Code 52 and do not have any of the procedural rights protected by the bankruptcy public policy. The expense of creating a CDO structure, however, may not be practical nor may subordinate lenders agree to be completely silenced in this manner. 5. Injunctive Enforcement Against Mezzanine Lenders. Enforceability of rights and waivers of mezzanine lenders in intercreditor agreements are more likely to arise outside of the bankruptcy courts because the rights possessed by holders of unsecured mezzanine debt are less in a bankruptcy than the rights of second lien holders as secured creditors. In three nonbankrupcy cases, courts have upheld the enforceability of the CMBS form intercreditor provision requiring the mezzanine lender to cure all outstanding defaults under the senior loan as a condition precedent to taking control of the borrower through a foreclosure of the mezzanine interests. The provision at issue in the cases provides: To the extent that any Qualified Transferee acquires the Equity Collateral pledged to a Junior Lender pursuant to the Junior Loan Documents in accordance with the provisions and conditions of this Agreement... such Qualified Transferee shall acquire the same subject to (i) the Senior Loan and the terms, conditions and provisions of the Senior Loan Documents...which shall not be accelerated by Senior Lender or the Related Junior Lender solely due to such acquisition and shall remain in full force and effect; provided, however, that...(b) all defaults under (1) the Senior Loan and (2) the applicable Senior Junior Loans, in each case which remain uncured or unwaived as of the date of such acquisition have been cured by such Qualified Transferee. 53 52 In re Shilo Inn, Diamond Bar, LLC, 285 B.R. 726 (Bankr. D. Or. 2002). 53 Id at 5. 13

Stuyvesant Town 54 involved Peter Cooper Village and Stuyvesant Town in New York City financed with a $3 billion senior loan and a $1.4 billion mezzanine loan. The senior loan has been accelerated for payment default and a judgment for foreclosure issued. PSW acquired some of the mezzanine loans and executed a representation certificate that it agreed to be bound by the intercreditor agreement. The next day PSW notified the senior lenders that PSW intended to sell the pledged equity interests at a UCC public sale. Counsel for the senior lenders requested that PSW provide evidence that it was a Qualified Transferee under the intercreditor agreement and confirm that it would cure the senior loan default as a condition to the UCC foreclosure, as required under Section 6(d) of the intercreditor agreement. When PSW responded that the cure was ludicrous and not required as a condition to the transfer, the senior lenders filed for a preliminary injunction. The court held Section 6(d) unambiguous and enforceable. The court found that the senior loan payment default was not a default that could only be cured by the mezzanine lender following its acquisition of interests in the borrower and denied any extended cure period. In U.S. Bank 55 the senior loan had matured and the mezzanine lender sought to complete its UCC foreclosure without having to pay the senior loan. The mezzanine lender argued that the intercreditor agreement recognized the right of the mezzanine lender to foreclose and, having complied with all the express conditions in the intercreditor agreement to a UCC foreclosure, i.e. for a Qualified Transferee, a Qualified Manger and a hard cash management, it should not have to cure the default on the senior loan by payment in full. The U.S. District Court for Arizona held that paying the senior loan in full was pre-condition to the mezzanine foreclosure. In each case, the courts agreed with the intercreditor provision that monetary damages would be an inadequate remedy in the event of a breach of the agreement, and issued a preliminary injunction to enjoin the UCC sale and acquisition of the mezzanine interests until all sums due under the senior mortgage were paid in full. In each case, the courts were influenced by the intent of the mezzanine lender to place the debtor into bankruptcy following the UCC foreclosure. The Stuyvesant Town judge noted that the mezzanine lender had purchased the mezzanine debt at a steep discount and had stated its intention to place the debtor into bankruptcy immediately after the UCC foreclosure. The courts also recognized that the intercreditor agreement would expire upon completion of the UCC foreclosure and thereafter the mezzanine lender would no longer be prohibited under its terms from placing the borrower into bankruptcy. 54 Bank of America N.A. v. PSW NYC LLC, 918 N.Y.S.2d 396, 2010 WL 42433437 (N.Y. Sup. Ct. 2010); See also CSMSC 2007-C2 Broadway Portfolio II, LLC v. OREP/Oxford HY Venture Funding 4, L.P., Index No. 652809/2011 (N.Y. Sup. Ct. December 15, 2011). 55 U.S. Bank National Association v. RFC CDO 2006-1, Ltd., Case No. 4:2011cv00664 (D. Ariz., Dec. 6, 2011). 14

One court has restricted the exercise by a mezzanine lender of collection rights against a guarantor based upon the standard CMBS language that the senior lender shall be entitled to receive payment and performance in full of all amounts due or to become due to senior lender before mezzanine lender is entitled to receive any payment on account of the mezzanine loan. In Highland Park 56 the mezzanine lender sued a guarantor, and the senior lender sought a declaratory judgment that the mezzanine lender should be barred from pursuing the guarantor prior to full payment of the senior loan. The court rejected the argument of the mezzanine lender that the subordination provision only related to the acceptance of payments from the borrower, and granted summary judgment and an injunction against the mezzanine lender exercising any right or remedy under the mezzanine loan guaranty until the senior lender received full payment and performance of all amounts due. CONCLUSION The conflict between the freedom of contract for creditors to agree among themselves with respect to their rights in a debtor bankruptcy and the position of upholding the balance of rights and remedies created by Congress under the Code has not been resolved. Most waivers and assignments of ancillary bankruptcy rights are enforceable, but a split in district bankruptcy courts over waivers and assignments of voting rights has not been settled by any Circuit Court. 57 A court may support the action of a subordinate lender who has a realistic chance of recovery to assert certain substantive rights such as voting. To a large extent, the willingness of bankruptcy courts to examine and enforce intercreditor agreements may depend upon timing of the presentation of the issue. In an early stage of a case, the bankruptcy court may lack the jurisdiction to determine the question, which if presented later may be core to the fundamental policies of the Code and to the resolution of the bankruptcy. A court is more likely at later stages of a Chapter 11 case to find that a provision encroaches upon a substantive bankruptcy right. 58 In addition, enforceability may depend upon whether the action of the subordinate lender sought to be silenced was explicitly drafted into the intercreditor agreement, and whether the subordinate lender exhibits obstructionist behavior or has a realistic opportunity of recovery. Senior lenders should explicitly list each bankruptcy 56 Highland Park CDO I Grantor Trust, Series A v. Wells Fargo Bank, N.A., 2009 U.S. Dist LEXIS 53272 (S.D.N.Y. 2009); Compare Capital Trust, Inc v. Lembi, No. C-09-02492, 2009 U.S. Dist. LEXIS 90001 (N.D. Cal Sept. 16, 2009) that allowed attachment by a mezzanine lender against a guarantor over senior lenders objections, although noting there may be claim for breach of intercreditor agreement. 57 Seth Jacobson, Ron Meisler, Matt Kriegel, Katherine Field, Enforceability of Intercreditor Agreements in Bankruptcy, 20 Norton J. Bankr. Law & Practice 343 (2011). 58 Hon. Arthur J. Gonzalez, Hon. Robert D. Drain, Hon. James M. Peck, Marc Abrams, and Michael L. Bernstein, Bankruptcy Court Jurisdiction over Intercreditor Issues and Subordinate Financing Agreements, American Bankruptcy Institute Views From the Bench (October 1, 2010), p. 35. 15

right to be silenced rather than rely upon general language. Conversely, subordinate lenders will seek general language and should be prepared to demonstrate that there is sufficient value in the assets to entitle them to a recovery and that they are not obstructionist to a reorganization. The senior creditor should also carefully consider whether the time and expense involved in contesting the action by the subordinate lender justifies the resulting delay in the final realization of the collateral or confirmation of a plan of reorganization. Under some circumstances to avoid deterioration in the value of the collateral, the position of the senior lender may be improved by an agreement with the subordinate lender reached early in the bankruptcy case on what rights may be exercised by the subordinate lender. August 17, 2012 16