Subordination Agreements and Voting Rights Will Your Inter-creditor Agreement Be Enforced

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Jul/Aug 2001

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Due to the complexity of multi-tranche financing in today's lending transactions,
inter-creditor subordination agreements, which provide for priority in debt and/or
collateral, are common. Indeed, a commercial debtor with a single lender is more
the exception than the rule. Congress has recognized this fact by enacting <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §510(a)</a>, which recognizes subordination agreements and gives due deference
thereto.

Certain subordination agreements, however, seek to control more than the priority
of debt and/or collateral. In fact, a recent trend has seen the use of
subordination agreements to control voting rights in connection with a chapter 11
reorganization plan. Such agreements may seem innocuous upon execution, but when a
proposed plan unfairly impairs the rights of the subordinated creditor in favor of the
senior creditor, such agreements can be very detrimental and seemingly contradictory to
the Bankruptcy Code.

In fact, certain courts have held that subordination agreements that transfer voting
rights impermissibly violate the Bankruptcy Code and, therefore, are not enforceable.
This recent trend is important due to implications often not foreseen at execution,
not to mention the voting of claims of a fragmented bank group.

<h3>Subordination Agreements</h3>

Pursuant to §510(a), "a subordination agreement is enforceable in a case under
this title to the same extent that such an agreement is enforceable under applicable
non-bankruptcy law." Based on the express language of §510(a), courts have
generally held that a subordination agreement affecting a subordinated creditor's voting
rights is fully enforceable in bankruptcy, thereby allowing the senior creditor to vote
the subordinated creditor's vote. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Curtis Center Limited Partnership, 192
B.R. 648, 658-59 (Bankr. E.D. Pa. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Inter Urban
Broadcasting of Cincinnati Inc., 1994 WL 646176, at *2 (E.D. La.
Nov. 16, 1994)</a>.

In both Curtis Center and Inter Urban, however, the debtor/plan proponent raised
the objection to the senior creditor voting the subordinated creditor's claim. In
fact, in neither Curtis Center or Inter Urban did the subordinated creditor object,
thereby fully acquiescing to the senior creditor. Based partially on the lack of such
an objection, both cases were summarily decided without considering the underlying policy
of voting under the Bankruptcy Code.

Recently, however, the bankruptcy court for the Northern District of Illinois
considered this very argument and held that a senior creditor is not entitled to vote
a subordinated claim, despite provisions in the agreement that allow the senior creditor
to do so. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re 203 North LaSalle Street Partnership,</a><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 246 B.R. 325
(Bankr. N.D. Ill. 2000)</a>.

<h3>203 North LaSalle's Holding</h3>

In 203 North LaSalle, the intercreditor subordination agreement provided that the
senior creditor could "vote or consent in any [chapter 11] proceedings with respect
to any and all claims relating to the junior indebtedness." Prior to confirmation,
the senior creditor sought a declaratory judgment action seeking a declaration that it
was entitled to vote the subordinated creditor's claim in the forthcoming confirmation
proceeding.

In determining the propriety of the subordination of voting rights, the court
examined the unambiguous language of the subordination agreement, along with
§510(a)'s language, and opined that <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1126(a)</a> governs the
determination of voting rights.

Section 1126(a) states that the holder of a claim may vote to accept or
reject a plan under chapter 11, which is not disregarded by a subordination agreement
because pre-bankruptcy agreements do not override contrary provisions of the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Code. 203 North LaSalle, 246 B.R. at 331</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Levinson,

831 F.2d 1292, 1296 n. 6 (7th Cir. 1987)</a> (where the court
refused to enforce a pre-bankruptcy provision controlling the dischargeability of certain
debts). The court further reasoned that "since bankruptcy is designed to produce a
system of reorganization and distribution different from what would [be] obtain[ed] under
non-bankruptcy law, it would defeat the purpose of the Bankruptcy Code to allow
parties to provide by contract that the provisions of the Bankruptcy Code should not
apply." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… North LaSalle, 246 B.R. at 331</a>.

The court further stated that §510(a) does not allow for the waiver of voting
rights because, inter alia, the definition of "subordination" is "the act or process
by which a person's rights or claims are ranked below those of others." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;; citing
Nolan, Joseph R., and Nolan-Haley, Jacqueline M., Black's Law Dictionary 1426
(6th ed. 1990). The court reasoned, therefore, that subordination does not
affect the transfer of voting rights, as the concepts are by definition exclusive.

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Foods Co. v. Hart Ski Mfg. Co. (In re Hart Ski
Mfg. Co.), 5 B.R. 734, 736 (Bankr. D. Minn. 1980)</a> (which
stated, in dicta, that the Code guarantees each secured creditor certain rights,
regardless of subordination including the right to participate in the voting for
confirmation or rejection of any plan of reorganization).

The court found further support for its holding in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Rule of Bankruptcy
Procedure 3018(c)</a>, which provides that an acceptance or rejection of a chapter
11 plan must be signed by the creditor or an authorized agent. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… North
LaSalle, 246 B.R. at 331</a>. The court noted that an "agent" acts at the
direction of a principal. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… North LaSalle, 246 B.R. at 331-32</a>; citing

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Brunswick Leasing Corp. v. Wisconsin Central Ltd., 136 F.3d 521,
526 (7th Cir. 1998)</a> (where the court stated that the test of agency is
the existence of the right to control the method or manner of accomplishing a task
by the alleged agent). Since the senior creditor in 203 North LaSalle acted in
its own interests, as opposed to the interests or at direction of the subordinated
creditor, no agency relationship existed. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… North LaSalle, 246 B.R. at
331-32</a>. And, since no agency relationship existed, the senior creditor could
not vote the subordinated creditor's claim. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

The court's decision not to enforce the transfer of the voting rights provisions of
the subordination agreement was based largely on underlying policy and the express language
of §1126(a) and rule 3018. Considering 203 North LaSalle's agency holding,
it may find future application to a fragmented bank group (i.e., where domestic
banks, foreign banks and private investment funds, all of whom answer to different
regulatory authority, are participants). Although bank groups typically execute an agency
agreement, the agent of a fragmented bank group is not always acting in the best
interests, or at the direction of the entire bank group. Indeed, most bank group
agency agreements provide for a majority vote, not a unanimous vote.

When an agent in such a situation votes the claims of its constituents, a dissenting
participant may very well object based on §1126(a), Rule 3018, and 203
North LaSalle's reasoning. After all, the dissenting participant has a claim against
the debtor, and the agent is no longer acting at its direction. Such a holding could
cause great disruption when bank groups are involved in a bankruptcy because of the
potential for additional litigation arising from such issues, not to mention a potential
confirmation objection based on the gerrymandering of diverse bank group interests into one
or more classes.

<h3>Conclusion</h3>

Prior to the execution of future subordination agreements, the senior creditor should
consider revamping its provisions regarding voting rights so that an agency relationship
is created, as opposed to the mere transfer of a voting right. While such language
may be interpreted as a transparent attempt around 203 North LaSalle, it may create
enough differences to allow the senior creditor the ability to vote on the subordinated
claim.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Sunday, July 1, 2001 - 12:00

Bankruptcy Rule

2001