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JANUARY 24, 2012 The enforceability in proceedings of waiver and assignment of rights clauses within intercreditor or subordination agreements

By Mark N. Berman and David Lee

This Alert provides you with a copy of a law review article co-authored by Mark N. Berman and David Lee discussing the development of case law addressing the enforceability in bankruptcy cases of provisions in intercreditor and subordination agreements that impact a party’s rights in a borrower’s bankruptcy case. It is reprinted with permission from Norton Journal of Bankruptcy Law and Practice, Volume 20, No. 6, December, 2011.

Modern business financing is often structured with multiple lenders and multiple tranches of debt. While it is possible to utilize a single credit agreement in which the relative rights of all lenders are spelled out in detail, lenders often employ a separate credit agreement for each tranche of debt.1 The use of multiple credit agreements requires that the relationship between the lenders be set forth in a separate inter- or subordination agreement2 which defines the relative rights of each tranche of lenders vis a viz the other tranches. An intercreditor agreement can be expected to address issues including and payment priority, modifications of the credit agreement, the pursuit of remedies

1 There can be several reasons to favor a single credit agreement including the use of a single agent for all lenders. One concern, though, is that using a single credit agreement may cause the various tranches of debt to be treated as a single loan in a borrower’s bankruptcy case. If the collateral that secures the loan is worth less than the total outstanding loan obligations, then the loan would be underwater and, therefore, not entitled to accrue postpetition interest or fees in a borrower bankruptcy case. See In re Ionosphere Clubs, Inc., 134 B.R. 528, 22 Bankr. Ct. Dec. (CRR) 651, 26 Collier Bankr. Cas. 2d (MB) 955 (Bankr. S.D. N.Y. 1991). 2 For purposes of this article, the words’ intercreditor’ and ‘subordination’ when referring to agreements of that sort, will be used interchangeably. See In re of New England Corp., 364 F.3d 355, 361, 42 Bankr. Ct. Dec. (CRR) 243, 51 Collier Bankr. Cas. 2d (MB) 1634, Bankr. L. Rep. (CCH) P 80079 (1st Cir. 2004) (citing 4 Lawrence P. King, et al., Collier on Bankruptcy ¶ 510.03 [2] at 5 10-7 (15th rev. ed. 2003) (“Subordination agreements are essentially intercreditor agreements.”) See also Section I, A.1 of this article and Berman and Brighton, Handbook on Second Lien Loans and Intercreditor Agreements, p. 77-78, American Bankruptcy Institute, 2009 (hereinafter, “ABI Handbook”).

Mark N. Berman is a Partner at Nixon Peabody LLP resident in its Boston and New York City offices and David Lee is an Associate at Nixon Peabody LLP resident in its New York City office. The views expressed in this article are the personal views of the authors and not those of Nixon Peabody LLP. against the borrower in the event a shall occur, the right to vote on a borrower’s Chapter 11 plan and otherwise be heard in a borrower’s bankruptcy case, etc.

With the increase in second lien financing experienced after the beginning of the new millennium, the negotiation and drafting of inter-creditor agreements became more complex. Increasingly subordinated lenders resisted efforts by senior lenders to place limitations on their rights in a borrower’s bankruptcy case. Sparse and conflicting case law made it difficult to predict the likelihood that a bankruptcy court in a borrower’s bankruptcy case would enforce the new or revised language.

With the economic downturn of the last few years, the enforceability of intercreditor agreements in bankruptcy cases has received an increasing level of judicial attention. Part I of this article will provide an overview of the current state of case law regarding the enforcement of intercreditor agreements and will include an examination of the reasoning used in these decisions, identifying apparently inconsistent results where they exist. Part II of this article will look at what the authors believe are flaws in the current legal analysis employed in the case law, identify what the authors believe are the issues that must be confronted by the courts, and suggest some structuring and drafting considerations.3

I. Where we are: the current state of case law A. Section 510(a) of the Bankruptcy Code

Intercreditor agreements in the first/second lien financing context typically provide that junior or second lien lenders are subordinated to senior or first lien lenders in terms of their respective rights to the shared collateral. While, in the absence of a default, the second lien lenders enjoy the same rights to payment from the borrower as are enjoyed by first lien lenders, upon the occurrence of a default under the second lien credit agreement, the intercreditor agreement can be expected to limit the rights of the subordinated lenders by imposing a standstill requirement restricting for some period of time the right of subordinated lenders to proceed with an enforcement action against the or the common collateral and blocking continued interest payments by the borrower to the subordinated lenders. Intercreditor agreements also typically limit other “ancillary” rights of the subordinated lenders with the limitations, usually in the form of a waiver or assignment of the subordinated lender’s rights, designed to protect the first lien lender’s efforts to work out the problem with the borrower or to realize upon the common collateral without interference from the subordinated lenders, particularly in the context of a borrower bankruptcy case. Such ancillary rights might include, inter alia: limitations on the right to seek relief from the automatic stay, to offer debtor-in-possession financing or to propose a plan, consent to the debtor’s use of the subordinated lenders’ cash collateral, consent to debtor-in-possession financing provided by the senior lenders, a waiver of the right to seek adequate protection of the subordinated lenders’ interest in shared collateral, consent to the sale of shared collateral, agreement not to contest the priority, validity, or

3 Intercreditor agreements are used in various types of financing arrangements and the provisions one is likely to see can differ from type to type. For example, an intercreditor agreement used in the syndicated second lien financing of a large manufacturing business may look very different than a subordination agreement used in the mezzanine financing of a large real estate project. For most purposes, unless otherwise indicated, the subject of the discussion in this article will be of a second lien financing.

- 2 - perfection of the lien on the common collateral enjoyed by the senior lenders, the right to vote the subordinated lenders’ claim in the bankruptcy case, and the imposition of subordination terms on securities that might be distributable to subordinated lenders under a plan. In their effort to avoid becoming irrelevant in the bankruptcy context, subordinated lenders might negotiate to limit the waiver or assignment provisions sought by senior lenders and for the insertion into the inter-creditor agreement of provisions that will limit the amount of debtor-in-possession financing that can be imposed senior to their lien, to retain rights they would otherwise have as unsecured , or the right to acquire the senior lenders’ claims upon the occurrence of certain triggering events.

The question is whether these negotiating and drafting efforts will result in an agreement that will be enforced by the bankruptcy court in which the borrower’s bankruptcy case is pending. The Bankruptcy Code addresses this subject in a somewhat innocuous way. Section 510 of the Bankruptcy Code4 provides in its entirety:

A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.

Some of the legal questions that arise from this simple sentence are not so easy to answer.

1. Just what is a subordination agreement?

What exactly is a “subordination agreement?” The term is not defined in the Bankruptcy Code. However, in line with the approach taken by the U.S. Supreme Court, we can turn to Black’s Law Dictionary for guidance.5 The term “subordination agreement” is defined therein as “SEE AGREEMENT.” Oops . . . that’s not much help. However, the word “subordination” and the term “subordination clause” are both defined as follows:

subordination, n. 1. The act or an instance of moving something (such as a right or claim) to a lower rank, class, or position [subordination of a first lien to a second lien]. [Cases: Secured Transactions [key number] 147.] 2. Parliamentary law. The status and relation of a lower-ranking governing document to a higher-ranking one. • A higher-ranking document supersedes and controls a subordinate document if there is any inconsistency between them. See governing document under DOCUMENT. – subordinate, adj.

subordination clause, 1. In a legal instrument, a clause that explicitly acknowledges the one party’s claim of interest is inferior to that of another party.

4 11 U.S.C.A. § 510(a). 5 Gardner, Black’s Law Dictionary, p. 1563, ((West, 9th Ed. 2009). See, e.g., U.S. v. Denedo, 556 U.S. 904, 129 S. Ct. 2213, 2219, 173 L. Ed. 2d 1235, 51 A.L.R. Fed. 2d 759 (2009) (“Though § 1259 does not define the term [‘relief’], its familiar meaning encompasses any ‘redress or benefit’ provided by a court. Black’s Law Dictionary 1317 (8th ed. 2004)”); CSX Transp., Inc. v. Alabama Dept. of Revenue, 131 S. Ct. 1101, 1108, 179 L. Ed. 2d 37 (2011) (“The statute does not define ‘discriminates,’ and so we again look to the ordinary meaning of the word . . . ‘Discrimination’ is the ‘failure to treat all persons equally when no reasonable distinction can be found between those favored and those not favored.’ Black’s Law Dictionary 534 (9th ed. 2009)”).

- 3 - 2. A covenant in a junior mortgage enabling the first lien to keep its priority in case of renewal or refinancing. [Cases: Mortgages [key number] 159.] 3. In a legal instrument, a clause that explicitly subjects its provisions to those in a higher ranking document.

Remarkably, few cases have addressed this question. Whether labeled a subordination agreement, an interecreditor agreement, or a subordination and interecreditor agreement, most courts have simply jumped their analysis ahead to examine the specific provision(s) of the agreement before them to determine how that provision should be interpreted and whether it is enforceable either as a matter of state law or federal bankruptcy law. However, the issue is important as is evident by the one case where the court did address the issue. Bankruptcy Judge Wedoff, in his decision in the 203 North LaSalle case,6 rejected a senior lender’s attempt to vote the claim of the subordinate lender, a right held by the senior lender according to the relevant subordination agreements entered into by the two lenders. In doing so, he had the following to say about what is a subordination agreement:

“Subordination,” though not defined by the Code, has a common understanding in the law, reflected in Black’s Law Dictionary, which defines subordination as: “The act or process by which a person’s rights or claims are ranked below those of others.” Joseph R. Nolan and Jacqueline M. Nolan-Haley, Black’s Law Dictionary 1426 (6th ed. 1990). Subordination thus affects the order of priority of payment of claims in bankruptcy, but not the transfer of voting rights.

The issue should not be overlooked. Most bankruptcy decisions dealing with the intercreditor and subordination agreements do not involve direct challenges to the enforcement of provisions dealing with lien or payment priority that clearly fall within the definition of “subordination,”7 but rather involve the subordinated lender’s “ancillary” bankruptcy rights, i.e., rights which one might argue do not “subordinate” a lender’s claim and, therefore, do not become enforceable via § 510(a).

The Hart Ski decision8 also touched the subject. Cited by Judge Wedoff in 203 North Lasalle to support the proposition quoted above, Hart Ski looked at whether the subordinate ’s broad waiver of enforcement rights in the subordination agreement prohibited it from seeking adequate protection for its in the debtor’s property or was entitled in the absence of adequate protection to relief from the automatic stay. Bankruptcy Judge Dim, holding that the waiver provision was not enforceable, said:

[t]he intent of § 510(a) (subordination) is to allow the consensual and contractual priority of payments to be maintained between creditors among themselves in a bankruptcy proceedings. There is no indication that Congress intended to allow

6 In re 203 North LaSalle Street Partnership, 246 B.R. 325, 35 Bankr. Ct. Dec. (CRR) 219, 43 Collier Bankr. Cas. 2d (MB) 1463 (Bankr. N.D. Ill. 2000). 7 These cases deal with interpretation rather than enforcement of the provision, i.e. what does the provision mean rather than whether the bankruptcy court should enforce the provision at all. 8 In re Hart Ski Mfg. Co., Inc., 5 B.R. 734, 736, 6 Bankr. Ct. Dec. (CRR) 968, 2 Collier Bankr. Cas. 2d (MB) 1189, Bankr. L. Rep. (CCH) P 67691 (Bankr. D. Minn. 1980).

- 4 - creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets.9

Of course, there are at least two sides to this argument. The 203 North LaSalle and Hart Ski cases are the primary decisions to date holding that a subordinated creditor’s wavier of its ancillary bankruptcy rights in a prepetition subordination agreement is not enforceable in the borrower’s subsequent bankruptcy case. In contrast, a majority of cases decided to date support the enforceability of intercreditor agreement provisions that involve the waiver or conditioning of one or more of a subordinate lender’s ancillary bankruptcy rights. These ancillary bankruptcy rights reach beyond the simply priority of distribution on a claim or from the proceeds of collateral to restrict a right the subordinate lender would otherwise enjoy in a borrower’s bankruptcy case.10

In support of the should be enforceable side of the argument, the definition of “subordination” set forth above references a “right” as well as a “claim.” Furthermore, the words in § 510(a) are not circumscribed by the limited notion of a claim. It is certainly possible that § 5 10(a) contemplates the subordination of rights as well as claims.

The right of a subordinate lender to take various actions in a bankruptcy case might very well impact the senior lender’s ability to realize on its senior claim, and, therefore, be an appropriate focus for the senior lender in the context of entering into an intercreditor agreement. Take, for example, the subordinate lender’s right to adequate protection. Assume that the senior and subordinate lenders have a lien on all of the borrower’s assets and these assets are worth less than the aggregate of the claims of the senior and junior lenders. If the subordinate lender is able to obtain from the bankruptcy estate adequate protection payments during a Chapter 11 case, there will as a result be less in the bankruptcy estate available to satisfy the claims of the senior lender. Why, then, is it not appropriate for the senior lender to desire to limit the right of the subordinate lender to come ahead of the senior lender in this respect? While the adequate protection provisions of the Bankruptcy Code are certainly there for the protection of the subordinate lender’s interest in its collateral, what policy prohibits the subordinate lender’s waiver of that right to adequate protection?

While courts will generally look to legislative history for guidance in the absence of the statute having an obvious plain meaning, reference to legislative history in the case of § 510(a) is simply of no assistance.11

9 Hart Ski, 5 B.R. at 736. 10 See In re Erickson Retirement Communities, LLC, 425 B.R. 309, 52 Bankr. Ct. Dec. (CRR) 238, 63 Collier Bankr. Cas. 2d (MB) 1577 (Bankr. N.D. Tex. 2010) (holding that, pursuant to § 5 10(a). a subordination agreement barred a second lien lender from moving for the appointment of an examiner to look into the allocation of sale proceeds among different debtor entities); In re Ion Media Networks, Inc., 419 B.R. 585, 52 Bankr. Ct. Dec. (CRR) 140 (Bankr. S.D. N.Y. 2009) (holding that, pursuant to § 5 10(a), a subordination agreement barred a second lien lender from objecting to the confirmation of the debtor’s Chapter 11 plan on the basis of whether certain FCC licenses were subject to the first lien lenders’ ); In re Aerosol Packaging, LLC, 362 B.R. 43 (Bankr. N.D. Ga. 2006) (holding that, pursuant to § 510(a), the second lien lender’s agreement to permit the first lien lender to vote its claim was enforceable). 11 In comments about § 5 10(a) in both the House and Senate Reports , the only relevant comment is that “Subsection (a) requires the court to enforce subordination agreements.” See comments of (Footnote continued on next page)

- 5 - 2. Is the subordination agreement enforceable under applicable nonbankruptcy law?

Since § 510(a) provides that subordination agreements are enforceable “to the same extent that they are enforceable under applicable nonbankruptcy law,” the lien, payment, and ancillary provisions of a subordination agreement must be enforceable under “applicable non-bankruptcy law” in order to be enforceable in a bankruptcy case. So to what extent is a subordination agreement enforceable under applicable nonbankruptcy law?

First, applicable nonbankrutpcy law means both state and federal law.12

Second, given that an intrercreditor agreement is a contract, it is reasonable to expect that state laws applicable to contract formation13 and contract enforcement are applicable. The applicable state’s version of the Statute of Frauds or the “Rule of Explicitness”14 may impact enforcement in an appropriate case. However, it is unlikely that these features of state law will impact a typical bankruptcy case where the intercreditor agreement is one of the documents utilized in a first and second lien financing, the parties are sophisticated, and the intercreditor agreement is being utilized in connection with two credit agreements pursuant to which the lenders loaned the borrower money in exchange for the borrower’s promise to repay the loan with interest.

Third, bankruptcy courts regularly rely upon state law contract rules of interpretation to determine the meaning of the provisions of an intercreditor agreement. These rules might include requiring adherence to the ordinary or plain meaning of words or phrases, giving meaning to every word of the contract, construing ambiguity against the drafter of the agreement, discerning the intent of the parties, etc. We distinguish state law contract rules of interpretation from state law contract rules of enforcement.

Bankruptcy court decisions on the enforceability of intercreditor agreements tend to pay relatively little attention to state law on the enforceability of subordination agreements. They often substitute state contract interpretative rules for enforcement rules, refer generally to the enforcement of

(Footnote continued from previous page) Mr. DeConcini on the Bankruptcy Reform Act of 1978, 95th Cong. 2d Session, Report No. 95-989 (July 14, 1978), and comments of Mr. Edwards on Bankruptcy Law Revision, 95th Congress, 1st Session, Report No. 95-595 (September 8, 1977). 12 In re Bank of New England Corp., 364 F.3d 355, 42 Bankr. Ct. Dec. (CRR) 243, 51 Collier Bankr. Cas. 2d (MB) 1634, Bankr. L. Rep. (CCH) P 80079 (1st Cir. 2004). See also, ABI Handbook, pp. 79- 80. 13 Contract formation under state law usually requires an offer and an acceptance, the intent to contract or mutual assent, consideration, capacity and legality. See, generally, Calamari and Perillo, The Law of Contracts, 4th Ed. West 1998. The Uniform Commercial Code, as enacted in the individual states, provides at § 9-316 “Nothing in this article prevents subordination by agreement by any person entitled to priority.” 14 But see Bank of New England, 364 F. 3d 355. See also, Golfo v. Kycia Associates, Inc., 45 A.D.3d 531, 845 N.Y.S.2d 122, 124 (2d Dep’t 2007); In re Southeast Banking Corp., 156 F.3d 1114, 33 Bankr. Ct. Dec. (CRR) 302, 40 Collier Bankr. Cas. 2d (MB) 1238, Bankr. L. Rep. (CCH) P 77809 (11th Cir. 1998), certified question accepted, 92 N.Y.2d 945, 681 N.Y.S.2d 468, 704 N.E.2d 221 (1998), certified question answered, 93 N.Y.2d 178, 688 N.Y.S.2d 484, 710 N.E.2d 1083, 34 Bankr. Ct. Dec. (CRR) 326 (1999).

- 6 - subordination agreements under state law without looking to see if the state has any authority that supports enforcement of a specific ancillary bankruptcy right, or avoid searching for supportive state laws altogether. For example, in Aerosol Packaging,15 the bankruptcy court sitting in Atlanta examining a subordination agreement governed by the law of the state of Georgia simply reports that “[the subordinated creditor] has provided no evidence, argument or authority that the Subordination Agreement is not enforceable under applicable nonbankruptcy law.”16 In some cases the subject simply never comes up. In Erickson, the bankruptcy court in Dallas interpreting Maryland law found that “[u]nder Maryland law, subordination agreements are fully enforceable.”17 However, in support of that statement the Erickson court cited a decision of the U.S. District Court for the District of Maryland18 which enforced a subordination agreement, but that never examined any Maryland law other than that applicable to the interpretation rather than enforcement of contracts.

Occasionally, a more extensive analysis of state law can be found. For example, in19 Avondale Gateway Center Entitlement, the U.S. District Court for the District of Arizona spent considerable time examining the law of the State of Arizona in determining that a subrogation clause contained in a subordination agreement was enforceable to allow the senior lender to vote the claim of the subordinated lender. However, even that court’s more extensive analysis of state law was undertaken to interpret and give effect to the subrogation clause, rather than to determine whether state law would enforce a subrogation provision in a subordination agreement. The interpretive analysis was needed because the subrogation clause before the court did not speak specifically to voting rights so the court had to determine whether the right to vote would be expected to be included within the general right to subrogation granted by the subordinated lender to the senior lender.

The reality is that there are seldom any state laws that address enforcement of the waiver or assignment in a subordination agreement of a subordinate lender’s ancillary bankruptcy rights. State courts can be expected to have addressed enforcing the relative priorities to payment or to collateral as between the senior and subordinated lenders,20 but given that they don’t have jurisdiction over bankruptcy cases, and that most contested business reorganizations take place in bankruptcy court rather than state court, it is not realistic to expect that state courts have ever addressed, or will in the future ever address, the enforceability of an ancillary bankruptcy right, i.e., a right that should be

15 Aerosol Packaging, 362 B.R. 43. 16 Aerosol Packaging, 362 B.R. at 46. After reciting the wording of § 510(a), i.e., “[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law, the court posits that: “As a consequence, unless the Subordination Agreement is not enforceable under applicable nonbankruptcy law, the Subordination Agreement should be enforced by its terms.” This is questionable reasoning and one has to wonder why the burden was placed on the subordinated creditor to prove enforceability under applicable nonbankruptcy law. 17 Erickson, 425 B.R. at 315. 18 Mercantile-Safe Deposit & Trust Co. v. Mroz, 2009 WL 792276 (D. Md. 2009). 19 In re Avondale Gateway Center Entitlement, LLC, 2011 WL 1376997 (D. Ariz. 2011). 20 See § 9-316 of the Uniform Commercial Code: “Nothing in this article prevents subordination by agreement by any person entitled to priority.”

- 7 - peculiar to the bankruptcy case and a right granted by the Bankruptcy Code, and, therefore, not be addressed in state court.

3. The “plain meaning” of contracts: the importance (or not) of good drafting?

Either before or after the court determines that what it has in front of it is a subordination agreement as that term is used in § 510(a), and that the provisions of the subordination agreement at issue in the case are enforceable under applicable nonbankruptcy law, it is possible that the court will be called upon to interpret the provisions of the subordination agreement to determine what they mean. In this effort, the bankruptcy courts have been active, but not always been consistent.

As discussed above, this exercise is generally one of contract interpretation guided by state law contract interpretation rules.21 Some subordination agreements will contain a specific reference to the right(s) purportedly granted, assigned, or waived, making the court’s job an easy one, at least on the question of contract interpretation. Other subordination agreements rely upon general language forcing the court to determine exactly how much was contemplated by the parties. For example, in Aerosol Packaging,22 the subordination agreement made specific reference to the senior lender’s right to vote the junior lender’s claim in any borrower bankruptcy case and resulted in the court enforcing that right. Also, in Ion Media,23 the acts complained of, i.e., contesting the extent and priority of the senior lender’s lien and objecting to confirmation of a plan supported by the senior lender, were specifically addressed by the ‘No Contest’ and ‘Plan Support’ provisions of the intercreditor agreement. In contrast, Hart Ski saw a court asked to interpret a general ‘no interference’ clause to prohibit a subordinated creditor’s effort to obtain adequate protection and the court refused to do so.24

Where the drafting is clear, but for the question of bankruptcy public policy, the courts have generally been willing to enforce the agreement as written.25

Where the drafting is not clear, the result is much harder to predict. In Erickson,26 the intercreditor agreement did not specifically define the phrase “Enforcement Action” to include the right in a bankruptcy case to seek appointment of an examiner, yet the court held that when a subordinated lender filed a motion for appointment of an examiner, it violated that portion of the definition of “Enforcement Action” that restricted the subordinated lender from “exercising any rights or remedies or take any actions or proceeding to collect or enforce any of the Subordinated Obligations and “[waiver of] any principle or provision of law . . . which might be in conflict of this

21 See supra, question #2: Is the subordination agreement enforceable under applicable nonbankruptcy law? 22 Aerosol Packaging, 362 B.R. 43. 23 Ion Media Networks, Inc., 419 B.R. at 595. 24 Hart Ski., 5 B.R. at 735-736. 25 203 North LaSalle is an example of bankruptcy public policy coming into play to negate a clear provision in the subordination agreement granting the senior lender the right to vote the junior lender’s claim. 26 Erickson, 425 B.R. at 315.

- 8 - Agreement.”). In stark contrast, the Boston Generating court,27 faced with a subordinated lenders’ objection to a proposed § 363 sale, allowed the subordinated lenders to object to the § 363 sales in the face of an intercreditor agreement’s prohibition against subordinated lenders taking any action that would hinder an exercise of remedies by the senior lenders and specifically referenced the sale of collateral in that context. The court had some difficulty in doing so as it stated that “it [went] against the spirit of the subordination scheme” because it was “constrained by the language of the intercreditor agreement,” which appeared to permit such an objection.

The Boston Generating court’s decision relied in part on the form of § 6.2 of the ABA First Lien/Second Lien Intercreditor Agreement Task Force Model Intercreditor Agreement28 which does include a specific clause prohibiting subordinated lenders from contesting, protesting, or objecting to a § 363 sale of the collateral.

Subordinated lenders will, if the clause is present in the applicable subordination agreement, rely upon their reservation of rights as unsecured creditors to proceed with various objections or motions intended to impede or alter the senior lenders’ intended course of action. That reliance may be misplaced as the operative reservation of rights provision is usually introduced by the words “Except as otherwise specifically prohibited elsewhere in this agreement” or similar words.29

Bankruptcy public policy can also come into play to negate generalized language prohibiting subordinated lender actions.30

The conflict in the cases can be explained by a difference in state law rules of contract interpretation. For example, Judge Chapman in Boston Generating was constrained by New York State law that required a restriction on the subordinated lenders to be “express or intentional.”31 This reflection of the “Rule of Explicitness,” requires specificity in drafting those provisions in subordination agreements that affect ancillary bankruptcy rights. In contrast, Judge Jernigan in Erickson reviewed the applicable subordination agreements under Maryland law where the guiding principle was “what a reasonable person in the same position would have understood as the meaning of the agreement.”32 So the choice of law provision in an intercreditor agreement really does matter.

27 In re Boston Generating, LLC, 440 B.R. 302, 320, 54 Bankr. Ct. Dec. (CRR) 4 (Bankr. S.D. N.Y. 2010). 28 See The Business Lawyer; Vol. 65, May 2010, pages 809-883, and, specifically, pages 85 8-860. As far as these authors are aware, the Model Intercreditor Agreement has not yet been adopted for daily use by those who draft intercreditor agreements. However, if bankruptcy courts will, like the Boston Generating court did, compare the subordination language before them to the Model Intercreditor Agreement, drafters should consider spending time conforming their stock intercreditor and subordination documents to the Model Intercreditor Agreement. 29 See Ion Media, 419 B.R. at 598. 30 See Hart Ski, 5 B.R. 734. Hart Ski involved a generalized waiver clause which the court, for bankruptcy public policy reasons, would not enforce to restrict the junior lender from seeking adequate protection and relief from the automatic stay. 31 Boston Generating, LLC, 440 B.R. at 319. 32 Erickson, 425 B.R. at 314.

- 9 - The lesson from these cases is that in drafting an intercreditor agreement the party seeking to control the other should take care to cover by specific language every action that might conceivably be taken in the context of a borrower bankruptcy case. That’s a daunting assignment given the wide variation in issues that can arise and strategies that might be employed in a given bankruptcy case. However, as most syndicated intercreditor agreements tend to be governed by the law of the state of New York where explicit drafting is required, generalized language might just not do the trick.

4. Whether the intercreditor provision is unenforceable as a matter of “bankruptcy public policy”?

Two bankruptcy courts have held that certain provisions contained in subordination agreements are rendered unenforceable because they provide for the waiver or assignment of rights which cannot be assigned as a matter of public policy reflected in the Bankruptcy Code. The first was Hart Ski, one of the earlier bankruptcy court decisions to deal with ancillary bankruptcy rights, where the court held that an intercreditor agreement was not enforceable to the extent that it provided for the subordinated lender’s waiver of its right to seek adequate protection or relief from stay because “[t]he Bankruptcy Code guarantees each secured creditor certain rights, regardless of subordination,” which “cannot be affected by the actions of the parties prior to the commencement of a bankruptcy case.”33 Other ancillary rights the Hart Ski court mentioned as coming within this bankruptcy public policy exception to subordination agreement enforcement include filing a plan, voting on a plan, and objecting to confirmation.34

The other bankruptcy court decision using bankruptcy public policy to invalidate an ancillary bankruptcy rights provision in a subordination agreement is 203 North LaSalle, where the court looked to language in § 1126 of the Bankruptcy Code which specifies that only “holders of a claim” may vote such claims. In the court’s view, this language overrides any agreement that would provide otherwise. The court reasoned that § 1126 reflects Congress’ intent that even subordinated lenders be heard in the plan confirmation process and permitting the assignment of such rights would upset the scheme crafted by Congress.35 The 203 North LaSalle decision finds support in Hart Ski for this proposition. Both courts were critical of the proposition that prebankruptcy contracts can effectuate a waiver or assignment of bankruptcy rights. This issue has been explored by several bankruptcy courts after forbearance agreements began to include a borrower’s waiver of the automatic stay that arises upon the filing of a bankruptcy case.36 Reliance on this line of case law is subject to some

33 Hart Ski., 5 B.R. at 735. 34 Hart Ski., 5 B.R. at 735. 35 North LaSalle , 246 B.R. at 332 (“Congress may well have determined to protect that potential by allowing the subordinated claim to be voted. This result assures that the holder of a subordinated claim has a potential role in the negotiation and confirmation of a plan, a role that would be eliminated by enforcing contractual”). 36 See 11 U.S.C.A. § 362(a). No single rule emerged from the cases dealing with the enforceability of a prepetition waiver of the automatic stay. Some courts held that they were always enforceable. See e.g. In re Club Tower L.P., 138 B.R. 307 (Bankr. N.D. Ga. 1991). Others held that they were never enforceable. See e.g. Matter of Pease, 195 B.R. 431, 35 Collier Bankr. Cas. 2d (MB) 1408 (Bankr. D. Neb. 1996). Still others favored a case by case approach, see e.g. In re Powers, 170 B.R. 480, 25 Bankr. Ct. Dec. (CRR) 1586, 31 Collier Bankr. Cas. 2d (MB) 1079, Bankr. L. Rep. (CCH) P 76057 (Bankr. D. Mass. 1994), or developed a number of factors to weigh in each instance, see e.g. In re (Footnote continued on next page)

- 10 - criticism as the case law is not uniform, is generated primarily although not exclusively in the context of single asset real estate cases and since many of those decisions turned on the fact that that nondebtor parties to the bankruptcy case could raise the same issues that the debtor had arguably waived. Reliance on other parties in bankruptcy cases has no relevance in the context of objecting to a DIP financing motion where no other party may have the ability to make a competing proposal, or to plan proposal or confirmation where another party may not have an interest in proposing a plan or the same grounds for objecting to its confirmation.

Other courts appear to read such “bankruptcy public policy” based exceptions for enforcement more narrowly. In Aerosol Packaging, for example, the court held that while the “holder” of a claim is entitled to vote, there was nothing in the Bankruptcy Code prohibiting the assignment of such holder’s right to vote.37 In Ion Media,38 the court distinguished the relevant contractual provision in that case, i.e., forbidding second-lien lender from objecting to confirmation, from cases like 203 North LaSalle and Hart Ski, because Ion Media did not involve a dispute over the right to vote.39

5. Is someone here engaging in obstructionist behavior?

Courts in several very recent cases have considered as relevant whether a second-lien lender is engaging in “obstructionist behavior” when determining whether to enforce an intercreditor agreement that prohibits such behavior. For example, in Ion Media, a case where it was clear the court felt offended by the subordinated lender’s actions, the court held that “plainly worded contracts establishing priorities and limiting obstructionist, destabilizing and wasteful behavior should be enforced and lender expectations should be appropriately fulfilled.”40 In Erickson, the court held that seeking the appointment of an examiner was “the very type of obstructionist behavior” that subordination agreements seek to prohibit.41 In Boston Generating, the court felt that it was at least relevant to its determination that the second lien lender objecting to a § 363 sale appears to be “on

(Footnote continued from previous page) Desai, 282 B.R. 527 (Bankr. M.D. Ga. 2002). See generally, J. Baillie, Business Workouts Manual, Chapter 21, 2008 Thomson Reuters/West. 37 Aerosol Packaging, LLC, 362 B.R. at 47. 38 Ion Media, 419 B.R. at 595. 39 Ion Media, 419 B.R. at 595. The Ion Media court’s attempt to distinguish Hart Ski as limited to voting on a plan is mistaken as Hart Ski did not involve voting on a plan. Rather, it dealt with a waiver of the right to seek adequate protection. It should be note that § 1129(b) (1) of the Bankruptcy Code provides that a plan may be confirmed via cram-down “[n]otwithstanding section 5 10(a).” There is one published decision, In re TCI 2 Holdings, LLC, 428 B.R. 117 (Bankr. D. N.J. 2010), which finds that this language permits the confirmation of a Chapter 11 plan which contradicts the terms of the payment subordination provision within an intercreditor agreement. The TCI 2 case is not listed among the “public policy” exception cases since its reasoning relies on the explicit text of § 1129(b)(1) rather than a reference to bankruptcy public policy. 40 Ion Media, 419 B.R. at 595. The Court went so far as to suggest a measure of damages should the senior lender decide to sue the subordinated lenders for violating the intercreditor agreement. 41 Erickson, 425 B.R. at 315.

- 11 - the cusp of recovery” and was “not engaged in the type of obstructionist behavior identified . . . in Ion Media.”42

The term “obstructionist” is not defined in the Bankruptcy Code or by any court in any of these cases. It may relate to being among the last objectors to plan confirmation. It may also emanate from being deeply “out of the money” while aggressively pursuing a long shot that may enable one to recover or will delay the proceeding to pressure the senior classes to give something up in return for cooperation.43 On the other hand, the reference to “obstructionist behavior” may be a throwback to pre-Bankruptcy Code subordination agreement cases where the courts did not have § 510(a) of the Bankruptcy Code to hang their decision hats on and instead looked to concepts of equity to enforce subordination agreements.44

The use of “obstructionist behavior” to restrict or allow a lender from proceeding in accordance with an intercreditor agreement is troubling. There is nothing in § 510(a) to suggest that equitable considerations are relevant to the determination of a subordination agreement’s provisions being enforceable under “applicable nonbankruptcy law.” Perhaps justification would exist if the courts’ references to “obstructionist behavior” were couched in citation to “applicable nonbankruptcy law” where a state court found equitable considerations appropriate in its enforcement of subordination provisions. To date such references stand naked of any such reference and it is hard to see what place obstructionist behavior has in the context of an exercise in contractual interpretation.

B. Collective action and the subrogation clause

Whether an intercreditor agreement is employed in a financing structure is in part a function of whether the lending is taking place pursuant to a single credit agreement or more than one credit agreement. In the absence of at least two credit agreements, the intercreditor issues are deal with in the credit agreement itself or in a collateral agency agreement in which the lenders appoint a

42 Boston Generating, LLC, 440 B.R. at 320. 43 See Ion Media, 419 B.R. at 590 (the court noted that the objecting second lien lender was deeply out of the money, and the chapter plan has the support of vast majority of lenders, including other second- lien lenders); Erickson, 425 B.R. at 311 (the court noted that most of the original parties who moved for the appointment of the examiner have withdrawn such motion); Boston Generating, 440 B.R. at 320 (holding that the lender was not being “obstructionist” while noting that it is “on the cusp of recovery”); see also Beal Savings Bank, 8 N.Y. 3d 318 (in a “collective action” case, the majority of the appellate court noted held that a dissenting lender, which held less than 5% of the applicable class of claims, could not take an independent enforcement action; the dissenting opinion argued that it was not appropriate for the majority to look to the relative smallness of the lender’s holding as a factor in deciding against it). 44 See, e.g., In re Itemlab, Inc., 197 F. Supp. 194 (E.D. N.Y. 1961). However, reliance on the bankruptcy court’s equitable powers may be misplaced. See Levitan, “Toward a Federal Common Law of Bankruptcy: Judicial Lawmaking in a Statutory Regime,” 80 Am. Bankr. L.J. 1, 19-50 (2006). See also In re Kalikow, 602 F.3d 82, 52 Bankr. Ct. Dec. (CRR) 276, Bankr. L. Rep. (CCH) P 81728 (2d Cir. 2010) (an exercise of § 105 power must be tied to another section of the Bankruptcy Code, “not merely to a general bankruptcy concept or objective”). This raises the question, however, whether § 5 10(a) permits a bankruptcy court to look to a state court’s equitable powers as “applicable nonbankruptcy law” in determining whether or not to enforce a subordinate lender’s waiver or assignment of an ancillary bankruptcy right.

- 12 - representative to act on their collective behalves. These rights include those arising out of “collective action” clauses under which a group of lenders—typically syndicated lenders or bondholders within the same class—agree that an agent or trustee will act on behalf of the entire group upon the consent or vote of the applicable majority within the group of lenders. A corollary clause is also present requiring that no individual lender will take an independent enforcement action.45 Courts have found these agreements to be enforceable both within and outside bankruptcy.46

The enforcement of such “collective action” provisions in bankruptcy cases does not depend on § 5 10(a) of the Bankruptcy Code because the relevant provisions do not “subordinate” in the classic sense one lender to another. However, the outcome is often the same. If the lenders can only act through the collateral agent and a majority of lenders is required to direct the collateral agent to act, then the minority lenders’ view will always be “subordinated” to the view of the majority lenders. Erikson relied in part on this collative action rationale for its conclusion that the minority lender did not have standing to pursue its motion for the appointment of an examiner.47

A recent bankruptcy case illustrates another type of contract provision that could be enforceable without regard to § 5 10(a). Specifically, In re Avondale Gateway Ctr. Entitlement48 involves the same legal dispute as 203 North LaSalle and Aerosol, i.e., whether a senior lender can vote a junior lender’s claims pursuant to their intercreditor agreement. However, the intercreditor agreement in Avondale differed in that, in addition to subordination, it provided for the senior lender to be subrogated to the junior lender’s claims and rights until the senior lender was repaid in full.49 The Avondale court found that, under Arizona law, unlike subordination, which would simply provide the junior lender’s claim with a lower priority, when a senior lender is subrogated to a junior lender’s claim, the senior lender is deemed to step into the shoes of the junior lender with respect to all of its rights, including the right to vote the junior lender’s claim for or against the confirmation of a Chapter 11 plan.50 The Avondale decision explicitly distinguished subrogation from subordination and held that Hart Ski and 203 North LaSalle were inapplicable because they do not address subrogation.51

45 Beal Sav. Bank v. Sommer, 8 N.Y.3d 318, 834 N.Y.S.2d 44, 865 N.E.2d 1210 (2007), In re Chrysler LLC, 405 B.R. 84, 51 Bankr. Ct. Dec. (CRR) 181 (Bankr. S.D. N.Y. 2009), cert. granted, judgment vacated on other grounds, 130 S. Ct. 1015, 175 L. Ed. 2d 614, 48 Employee Benefits Cas. (BNA) 2952 (2009). 46 Chrysler, 405 B.R. 84 (bankruptcy case); Beal, 8 N.Y. 3d 318 (New York State court case); In re GWLS Holdings, Inc., 51 Bankr. Ct. Dec. (CRR) 72, 2009 WL 453110 (Bankr. D. Del. 2009); In re Metaldyne Corp., 409 B.R. 671 (Bankr. S.D. N.Y. 2009), aff’d, 421 B.R. 620 (S.D. N.Y. 2009). 47 Erickson, 425 B.R. at 314-315. 48 Avondale, 2011 WL 1376997. 49 Avondale, 2011 WL 1376997 at *4. 50 Avondale, 2011 WL 1376997 at *4. 51 Avondale, 2011 WL 1376997 at *4.

- 13 - II. Where we’re going: Is the current case law correct?

Only occasionally is a bankruptcy court asked to look at an intercreditor agreement to determine a matter of strict priority as between the senior and junior lenders.52 While cases addressing distribution priority can be interesting and instructive for those who draft future intercreditor agreements, they do not often impact the reorganization process, the prospects for the debtor’s business or have an impact on creditors of the debtor who are not party to the intercreditor agreement.

As the review of the case law above suggests, when bankruptcy courts are asked to enforce a provision in an intercreditor agreement, the dispute does not necessarily involve the priority of distribution amongst creditors, but rather one of the many “ancillary bankruptcy rights,” usually a right of the subordinate lender, that most intercreditor agreements attempt to restrict. What is at play in these cases is whether the subordinated lenders will either (i) be kept silent as senior lenders would like them to be, or (ii) maintain a voice and a seat at the table as every subordinated lender would prefer. These ancillary bankruptcy rights of the subordinated lender might impact events in the early stages of a reorganization proceeding, e.g., whether a subordinated lender can oppose DIP financing proposed or supported by senior lenders, whether a subordinated lender can propose alternative DIP financing in opposition to that proposed by senior lenders, what form that DIP financing might take, the right to seek adequate protection for their subordinated lien on the common collateral owned by the debtor, and the right to seek relief from the automatic stay in the absence of that adequate protection being provided. Ancillary bankruptcy rights also include those that impact the intermediate course of the reorganization proceeding as, absent the enforceability of an intercreditor provision to the contrary, a subordinated lender would have the right to oppose a § 363 lease or sale of assets to which the senior lenders consent, to seek the appointment of a trustee or an examiner, or the outright dismissal of the case. Ancillary bankruptcy rights can have a huge impact on the final stages of the reorganization by addressing who gets to vote the subordinated lender’s claim, whether the subordinated lender can propose an alternative plan at all, especially one that seeks to the , whether the subordinate lender can object to a disclosure statement presented in connection with a plan supported by the senior lenders, and whether the subordinated lender can object to the confirmation of that plan.

When bankruptcy courts are asked to enforce a waiver or assignment of one of the subordinate lender’s ancillary bankruptcy rights, the bankruptcy courts have not been consistent. Compare the result in 203 North LaSalle where the senior lender was prohibited from voting the claim of the subordinated lender, to the result in Aerosol where, on a substantially identical factual premise, the senior lender was allowed to do so. Part II of this Article will examine some of the issues either addressed or ignored by the case law and will attempt to suggest alternative drafting approaches that

52 It does happen. See In re Dura Automotive Systems, Inc., 379 B.R. 257 (Bankr. D. Del. 2007) (interpreting the X clause in an intercreditor agreement to determine to whom plan securities should be distributed); Bank of New England 364 F. 3d at 361 (examining whether postpetition interest was required to be paid to senior lenders); In re WestPoint Stevens, Inc., 333 B.R. 30 (S.D. N.Y. 2005), rev’d, 600 F.3d 231, 52 Bankr. Ct. Dec. (CRR) 265, Bankr. L. Rep. (CCH) P 81718 (2d Cir. 2010) (whether payment in full can be satisfied with delivery of equity interests in reorganized debtor).

- 14 - lenders’ counsel might want to consider to create greater predictability that the result desired will be achieved in the bankruptcy context.

A. Relevance of § 510(a) to ancillary bankruptcy rights

Most judicial efforts to determine whether to enforce a provision in an intercreditor agreement that waives or assigns a subordinate lender’s ancillary bankruptcy rights invariably begin by reciting the words of § 510(a) of the Bankruptcy Code, next look to state law to interpret the provision being pressed, and then consider bankruptcy public policy concerns. However, there is an as yet untested argument that a subordinated lender’s waiver or assignment of ancillary bankruptcy rights, i.e., those rights not directly related to the priority of distribution as between the parties, can never be enforceable under “applicable non-bankruptcy law,” the very test that § 510(a) imposes for a waiver or assignment of ancillary bankruptcy rights to be enforced. The Hart Ski and 302 North LaSalle opinions exhibit a refusal by those courts to allow senior lenders to vary by prepetition agreement rights granted to subordinate lenders by the Bankruptcy Code. Those cases touch the edges of this argument, but never get all the way there. The First Circuit’s Bank of New England decision, premised on a limitation of the equity power of the bankruptcy courts and the Supremacy Clause of the U.S. Constitution, presents the argument in its full light. If this argument is correct, then the wavier or assignment of a subordinate lender’s ancillary bankruptcy rights will not be enforceable under § 510(a) simply because state law allows for the enforcement of subordination agreements generally. And even if § 510(a) does not authorize these waivers or assignments, two questions remain. First, can subordinate lenders waive or assign their ancillary bankruptcy rights in a prebankruptcy agreement. Second, if so, are there any public policy issues peculiar to bankruptcy, i.e., bankruptcy public policy, which should limit that ability.

The Bank of New England Chapter 7 case involved a dispute between the holders of senior and subordinated debt of the bankrupt bank holding company. The notes had been issued pursuant to indentures governed by New York law. The subordinated note indentures contained subordination provisions that required senior debt to be paid in full before subordinated debt was entitled to anything. The Chapter 7 trustee liquidated the debtor’s assets and distributed the proceeds to pay in full the obligation owed to the senior note holders as of the date of the filing of the bankruptcy case, i.e., all unpaid principal plus accrued but unpaid interest up to the date of the filing. Even though additional proceeds of the were in hand, he did not distribute to the senior note holders any payment on account of postpetition interest. Instead, he filed a motion asking for permission to make a distribution to the subordinated note holders. As expected, senior note holders objected on the grounds that the subordination provisions in the indentures required that they receive all of the postpetition interest that they asserted had accrued on the senior notes until they had been paid in full.53 The bankruptcy court granted the Chapter 7 trustee’s motion allowing the distribution to

53 The indentures did not have what has become a typical provision in an intercreditor agreement speaking directly to the ability of senior lenders to receive postpetition interest before any distribution to the subordinate lenders. It is commonplace for an intercreditor agreement to include within its definition of Senior Debt the phrase “and including interest, fees, cost, charges, expenses and other amounts accruing or incurred during an Proceeding whether or not such amounts are allowed or allowable in whole or in part in any such Insolvency Proceeding). See ABI Handbook, pages 28–29.

- 15 - subordinated note holders to proceed because the Rule of Explicitness, applicable because the indentures were governed by New York law, required that if a subordination agreement is to be interpreted as subordinate creditor consent to the payment of postpetition interest on senior claims from funds that would otherwise be payable to subordinated creditors, the language of the subordination agreement to that effect must be explicit in order to be enforced. In the bankruptcy court’s view, later affirmed by the district court, the indenture’s language about payment in full did not refer to postpetition interest and, therefore, was not sufficiently explicit to warrant payment of postpetition interest to senior note holders before any payment was made to the subordinated note holders.

The First Circuit reversed.54 In its view, the Rule of Explicitness had not survived the enactment of the Bankruptcy Code in 1978.55 Instead, reference was required to New York’s rule of contract construction that requires the court to glean the intent of the parties.56 The case was sent back to the bankruptcy court for further proceedings so that it could determine that intent.57

As noted by the First Circuit in its Bank of New England opinion, the now superseded Bankruptcy Act did not contain any language regarding the enforcement (or nonenforcement) of subordination agreements. Into that vacuum stepped the equitable power of the bankruptcy courts that enforced subordination agreements on equitable grounds because it was the right thing to do.58 However, according to the First Circuit, a bankruptcy court’s equitable power is greatly constrained under the Bankruptcy Code and “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”59

In Bank of New England, the First Circuit held that § 5 10(a) is such a “constrain[t]” upon the bankruptcy court’s equitable powers. Because § 510(a) dictates that subordination agreements be enforced to the same extent that they are enforced under “applicable non-bankruptcy law,” in the view of the First Circuit bankruptcy courts no longer have the equitable discretion to apply the “Rule of Explicitness” fashioned by bankruptcy courts in determining whether to allow senior creditors priority with respect to post-petition interest.60 In fact, § 510(a) “requires courts to reference general

54 Bank of New England, 364 F. 3d 355. 55 Bank of New England, 364 F. 3d at 359. 56 Bank of New England, 364 F. 3d at 359. 57 Further hearings were conducted after which the bankruptcy court ruled that the parties did not intend that senior note holders would receive postpetition interest before subordinated note holders received a distribution. That ruling was upheld by the First Circuit. See In re Bank of New England Corp., 646 F.3d 90, 55 Bankr. Ct. Dec. (CRR) 2 (1st Cir. 2011). 58 Bank of New England, 364 F.3d at 362. See In re Credit Indus. Corp., 366 F.2d 402, 22 A.L.R.3d 897 (2d Cir. 1966) (“These same [equitable] considerations, however, require that the concept of equal distribution be applied only to creditors of equal rank, i.e. creditors who are similarly situated. Creditors who expressly agree to subordinate their claims against a debtor and the creditors for whose benefit the agreement to subordinate is executed are not similarly situated.”) 59 Bank of New England, 364 F.3d at 362 (citing Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S. Ct. 963, 99 L. Ed. 2d 169, 17 Bankr. Ct. Dec. (CRR) 201, 18 Collier Bankr. Cas. 2d (MB) 262, Bankr. L. Rep. (CCH) P 72186 (1988)). See also Levitan, 80 Am. Bankr. L.J. 1, 19-50. 60 Bank of New England, 364 F.3d 355.

- 16 - principles of state contract law when enforcing subordination agreements, and it prohibits states from creating bankruptcy-specific rules of contract interpretation.”61 Since the Rule of Explicitness was a bankruptcy-specific rule, i.e., applicable only to whether post-petition interest would accrue on senior debt or not, it must yield via the Supremacy Clause to § 5 10(a).

Flowing from the Bank of New England decision, there is a significant problem looking to “applicable non-bankruptcy law” to resolve the enforceability of a waiver or assignment of a purely ancillary bankruptcy rights as these are bankruptcy-specific questions (such as post-petition interest, waiver of the right to vote, waiver of the right to object to a bankruptcy sale, etc.). A state law would typically not address such bankruptcy matters62 and, if it did without being a general principle of state contract law, the Supremacy Clause of the U.S. Constitution would dictate that such law cannot apply because it has been superseded by the Bankruptcy Code in the context of a bankruptcy case.

While, at first blush, the First Circuit’s approach (i.e., applying general principles applicable to contracts to the aspects of contracts addressing bankruptcy rights) may seem to resolve what “applicable non-bankruptcy law” means when the legal question is bankruptcy-specific, the approach remains problematic. First, if general state law principles are applied to the area of “bankruptcy,” wouldn’t this, by definition, be “bankruptcy law” rather than “non-bankruptcy law”? Second, it may be unlikely that one can find any general state law principles applicable to the enforcement, as opposed to interpretation, of subordination agreements.63 Moreover, it seems to be mere speculation for bankruptcy courts to guess at how general state law principles would work in the context of, for example, postpetition interest or assignment of voting rights.64

In the end, it appears that § 5 10(a) and “applicable non-bankruptcy law” does not provide a basis for determining whether a subordinated lender’s ancillary bankruptcy rights can be waived or assigned as part of an intercreditor agreement. Instead, bankruptcy courts are left in a position where they must

61 Bank of New England, 364 F. 3d at 359, 362 and 364. Bank of New England, 646 F.3d at 95.

62 This problem was recognized by the Eleventh Circuit when it rendered its decision in In re Southeast Banking Corp., 156 F.3d 1114, 33 Bankr. Ct. Dec. (CRR) 302, 40 Collier Bankr. Cas. 2d (MB) 1238, Bankr. L. Rep. (CCH) P 77809 (11th Cir. 1998), certified question accepted, 92 N.Y.2d 945, 681 N.Y.S.2d 468, 704 N.E.2d 221 (1998), certified question answered, 93 N.Y.2d 178, 688 N.Y.S.2d 484, 710 N.E.2d 1083, 34 Bankr. Ct. Dec. (CRR) 326 (1999) which certified the question as to New York State law to that state’s highest court. As explained by the Court of Appeals of New York, “The court then aptly noted that since the issue of post-petition interest arises exclusively in bankruptcy proceedings, New York courts have not previously considered the issue.”). 63 Bank of New England, 364 F.3d at 364-65 (“In view of § 510(a), we examined New York’s general principles of contract law and found that they ‘do not embody any canon that operates in the same manner as the Rule of Explicitness . . . Rather we found that New York courts do not appear to have developed any rules of interpretation that apply specifically to subordination agreements,” and that “the Rule of Explicitness is not part of New York’s general contract law.”) 64 For example, New York law provides that when a debtor makes an assignment for the benefits of creditors, a creditor’s right to postassignment interest is subject to something similar to the Rule of Explicitness. In re Southeast Banking Corp., 93 N.Y.2d 178, 688 N.Y.S.2d 484, 710 N.E.2d 1083, 1084-88, 34 Bankr. Ct. Dec. (CRR) 326 (1999). Does general New York contract law really provide a legal basis for either applying or not applying a Rule of Explicitness?

- 17 - look elsewhere. This may be why, when courts have looked at “non-bankruptcy law” to help them in their § 5 10(a) analysis, they tend to discuss the content of the nonbankruptcy law in a very cursory and abrupt fashion. B. Assuming § 510(a) doesn’t get you there, should a lender be able to waive or assign its own ancillary bankruptcy right?

Without the ability to rest the enforceability analysis on § 510(a), we are still left with a fundamental difference of opinion expressed in the case law concerning the right of a lender to waive or assign an ancillary bankruptcy right provided to that lender by the Bankruptcy Code. On the one hand, we have cases like 203 North LaSalle and Hart Ski where the bankruptcy courts refused to enforce the prebankruptcy waiver of a lender’s ancillary bankruptcy right based upon what, for lack of a better moniker, we have referred to as bankruptcy public policy. In 203 North LaSalle, dealing with the right to vote a claim, the court states “It is generally understood that prebankruptcy agreements do not override contrary provisions of the Bankruptcy Code . . . Indeed, since bankruptcy is designed to produce a system of reorganization and distribution different from what would obtain under nonbankruptcy law, it would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.”65 In Hart Ski, dealing with the right to adequate protection, the court states that “There is no indication that Congress intended to allow creditors to alter, by a subordination agreement, the bankruptcy laws unrelated to distribution of assets.”66

On the other hand, we have the Aerosol decision, which rejected the 203 North LaSalle reasoning. The Aerosol court found nothing in the Bankruptcy Code prohibiting a creditor from bargaining away its ancillary bankruptcy right, in that case the lender’s right to vote on a plan.67 We also have the Erickson decision in which the court stated that [i]t is well-settled that rights under statute may be contractually waived . . . This court is bound to pay deference to this waiver, pursuant to § 510(a) of the Bankruptcy Code.”68

So we are left with a fundamental disagreement. Should a lender, in a prebankruptcy agreement, be able to waive or assign a right granted exclusively to that lender by the Bankruptcy Code? There is little in the Bankruptcy Code to guide us. With minor exception, there is nothing in the text of the Bankruptcy Code suggesting that a creditor may or may not waive or assign a right provided to it by the statute. Sections 1123(a)(4), 1129(a)(9), 1222(a), and 1322(a)(2) may be read as such an authorization, but they are limited to the treatment of a claim under a plan and, therefore, applicable to the distribution scheme in bankruptcy cases and not to ancillary bankruptcy rights. Congress knew how to trigger a consideration of public policy by including a public policy exception into § 1506

65 In re 203 North LaSalle Street Partnership, 246 B.R. 325, 331, 35 Bankr. Ct. Dec. (CRR) 219, 43 Collier Bankr. Cas. 2d (MB) 1463 (Bankr. N.D. Ill. 2000)246 B.R. at 331. Citing to In re Cole, 226 B.R. 647,652 n.7, 33 Bankr. Ct. Dec. (CRR) 478 (B.A.P. 9th Cir. 1998) where footnote 7 contains a list of cases addressing the prebankruptcy waiver of bankruptcy rights. 66 Hart Ski, 5 B.R. at 736. 67 Aerosol Packaging, 362 B.R. at 47. 68 Erickson, 425 B.R.at 316.

- 18 - applicable to cross-border cases, which leads to the argument that public policy exceptions are not applicable to Chapter 7 or 11 cases.

Of course, the absence of permission to vary the terms of the Bankruptcy Code by waiver or assignment can be used by either side in a dispute or by the court in support of either conclusion. For example, it can be argued that there is nothing in the Code prohibiting a waiver or assignment of an ancillary bankruptcy right.69 However, it can be argued with equal force that the absence of permission from the legislature to vary the terms of a statute prohibits parties from entering into an agreement to vary its terms.70

Until the courts resolve this dispute, we are likely doomed to continue to move down these two irreconcilable paths when trying to determine the enforceability of waivers or assignments of ancillary bankruptcy rights. One path holds high the virtue of freedom of contract and permits creditors, as amongst themselves, to agree on whatever they would like as long as it is not specifically prohibited by applicable nonbankruptcy law or by the Bankruptcy Code. The other path holds high the virtue of a finely tuned Bankruptcy Code in which Congress balanced the rights and remedies of the various parties involved in a bankruptcy case. Followers of this path worry that tinkering by private parties will upset that fine balance such that the Code simply will not work as it was intended.71 Perhaps this is one of those areas where courts are ill-equipped to resolve what Congress intended or exactly what our public policy is. But waiting for Congress is probably no better than waiting for Godot.72

In the absence of definitive action from Congress, we suspect that the advocates for the no wavier or assignment of ancillary bankruptcy rights path will continue to occupy a minority position in the case law. The trend in this aspect of bankruptcy law has certainly been permissive. In bankruptcy cases, creditors are free to assign their claims both before and after the petition date.73 The transfer of a claim results in the transfer of all rights with respect to the claim, including the right to a distribution and all ancillary bankruptcy rights such as the right to vote, the right to seek adequate protection, the right to object to a § 363 sale, etc. Since a lender can assign its entire bundle of rights related to a claim, there doesn’t seem to be a cogent reason, certainly no public policy reason, why the lender should be prevented from giving up only a portion of its bundle of rights.

69 See Aerosol Packaging, 362 B.R. at 47 (“Section 1126(a) grants a 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.”). 70 Legislatures certainly know how to provide for the variance of a statute by agreement. Take, for example, Section 1-302(a) of the Uniform Commercial Code which provides that “Except as otherwise provided in subsection (b) or elsewhere in [the Uniform Commercial Code], the effect of provisions of [the Uniform Commercial Code] may be varied by agreement.” 71 One of the unfortunate realities is that there is little case law on these issues from the courts of appeal and none form the Supreme Court so there has been no opportunity to make the decisional authority uniform. 72 “Waiting for Godot” is a play written by Samuel Beckett in which the characters wait endlessly and in vain for someone named Godot to arrive. 73 See Fed. R. Bankr. P. 3001(e) which was amended in 1991 to allow claims trading with virtually no court involvement and no court approval required. Whether intended or not, the rule change has made claims trading easier and spurred its enormous growth.

- 19 - Perhaps one can argue that bifurcating ancillary bankruptcy rights from the claim perverts the motivations behind creditor actions in a bankruptcy case,74 but that same argument can be employed against claims trading in general as it allows a creditor or even an outsider to the case to acquire claims at various places in the debtor’s capital structure or at various times in a bankruptcy case and then use the power of that accumulated claim base to pursue the highest return on its investment, possibly at the expense of other creditors in the same class as one of the types of claims acquired.75 Does this risk upsetting a Congressionally conceived intricate balance of power embodied in the Bankruptcy Code? The ability to trade claims certainly changes the dynamic of the bankruptcy case. But while there can certainly be a difference of opinion as to whether that change is a good thing or not, having been permitted by a rule change there can be no sound argument that claims trading is against bankruptcy public policy. Enforcing ancillary bankruptcy provisions of intercreditor agreements, which provide for the waiver or assignment of the right to object, vote, etc., would not, therefore, seem to upset bankruptcy public policy any more than does the typical claims trading activity in bankruptcy cases or a lender’s prepetition assignment of its entire claim.

C. Drafting around the bankruptcy public policy exception

As we have seen, the bankruptcy public policy exception to enforcing the waiver or assignment of ancillary bankruptcy rights in an intercreditor agreement is based on the notion that the holder of a claim in bankruptcy case, even one whose claim is subordinated, has certain rights that as a matter of public policy cannot be waived or assigned. To prevent the application of the bankruptcy public policy exception, one can attempt to structure the transaction so that the subordinated party either does not hold a claim against the debtor and would not, therefore, have any nonwaivable/nonassignable procedural rights, or is part of a syndicate of lenders where the collective action rules may prohibit the lender from acting without the consent of the majority of lenders or the agent. While the structure employed will be the product of market forces that dictate what rights subordinated lenders are able to gather to themselves,76 enforceability may be more likely if the deal is documented in at least one of following three ways:

74 At its essence, this is the concern that fuels the bankruptcy public policy position that sits at the foundation of the Hart Ski and 203 North LaSalle decisions.

75 See Baird and Rasmussen, “Anti-Bankruptcy,” University of Southern California Law, Law and Economics Research Paper Series: USC CLEO Research Paper No. C09-8, University of Southern California Law, Legal Studies research Paper Series Paper No. 09-9 and University of Chicago, Olin Law and Economics Program, Research Paper Series: Paper No. 470; electronic copy available at http://ssrn.com/abstract=1396827. 76 These drafting observations are not intended to represent what the authors believe should be the result in any negotiated financial structure. That will be determined by the leverage available to the parties. Rather, the observations made here are simply that, i.e., observations as to what is possible to achieve the desired goal of predictability.

- 20 - 1. Subrogation clause

Under the doctrine of “subrogation,” the subrogee steps into the subrogor’s shoes with respect to all of the subrogor’s rights.77 The court in Avondale held that when an intercreditor agreement specifies that the senior lender is subrogated to all of the junior lender’s rights until the senior lender is paid in full, then the senior lender will be deemed to be the holder of the junior lender’s claim and can vote such claim. The effect is the temporary assignment, i.e., until the senior claim has been paid in full and in cash, of the claim from the subordinated lender to the senior lender.

While drafters of intercreditor agreements should consider whether a subrogation clause is useful for their transaction, and need to confirm that whatever state law will govern the agreement will work its intended magic, because a subrogee steps into the subrogor’s shoes with respect to all of its rights, including the right to payment, subrogation would effectively result in payment subordination (i.e., the junior lender cannot receive any payment until the senior lender is paid in full) in addition to lien subordination. The “all or nothing” nature of subrogation may be contrary to the parties’ bargain.78 To the authors’ knowledge, outside of the realm of certain real estate transactions, it is rare for parties to include subrogation clauses in intercreditor agreements.

2. The single credit agreement and collective action

When multiple tranches of debt are regulated by a single credit agreement, there is no need for a separate intercreditor or subordination agreement as the relationship of the holders of debt is determined primarily by the voting provisions in the single credit agreement. Once the required level of lender approval is achieved, the agent acts at the direction of the required lenders, but on behalf of the entire syndicate of lenders. If there is no subordination agreement, then § 510(a) simply doesn’t apply.

The collective action cases79 have uniformly rejected the ability of a subordinated lender to defy the will of the majority of lenders who have directed their agent to act on behalf of all lenders. As a result, the subordinated lender is more likely to be rendered silent through the agent’s consent to actions in the bankruptcy case like its consent to a sale of assets. However, as each lender is treated as having made a loan to the debtor and, therefore, has a claim against the bankrupt estate, this approach is less likely to be effective in the context of plan and disclosure statement issues where each lender will be entitled to vote. Careful draftsmanship will be required to spell out in detail what happens to each lender’s ancillary bankruptcy rights.

It is also not entirely clear that use of a single credit agreement will be effective in silencing recalcitrant lenders in the syndicate from exercising their ancillary bankruptcy rights, even in light of

77 Avondale, 2011 WL 1376997 (applying Arizona law). 78 Perhaps one way to address this issue is to include another provision under which the senior lender agrees to pay a portion of what it receives from the debtor to the junior lender. However, such a provision would not fully address the parties’ need to precisely define the specific rights that are waived and not waived. It would also raise its own legal and economic questions. 79 See Chrysler, 405 B.R. at 103, Metaldyne, 409 B.R. 671,GWLS Holdings, 2009 WL 453 110.

- 21 - a specific credit agreement wavier.80 Bankruptcy public policy will still have to be addressed and neither the agent, the majority lenders nor the court will be able to reference § 510(a) as the basis for enforcing the waiver.

3. CDO-type structured transaction

Another way to contract for the “silence” of a junior lender notwithstanding the bankruptcy public policy exception is to use a Collateral Debt Obligation (“CDO”)-type structure under which the actual junior (and senior) lenders do not directly hold a claim against the would-be debtor, but instead hold claims or interests with different priorities in a special purpose entity that holds the claim against the debtor. The varying rights of the senior and junior lenders could then be allocated as a matter of the corporate governance of the special purpose entity.

It is well-established that the lender of a lender or the equity holder of a lender is not a party in interest under the Bankruptcy Code.81 It follows that such a party is not entitled to the various procedural rights that the “public policy” exception purport to protect.

While this approach may effectively prevent the application of the “public policy” exception that allows a junior lender to exercise a procedural right that it has otherwise waived, there are drawbacks to this approach, including that creating a special purpose entity and structuring such a transaction as well as allocating rights among the lenders can be rather cumbersome process and, similar to the subrogation approach, may end up silencing the junior lender more than the parties intend.

III. Conclusion

Given the current state of case law, particularly those cases relating to the bankruptcy public policy exception and several recent cases looking to “obstructionist behavior,” it can be difficult to predict with certainty whether a bankruptcy court will enforce the waiver or assignment of ancillary bankruptcy rights as provided in most intercreditor or subordination agreements. While parties can attempt to draft around unfavorable case law, such an approach is not always realistic in terms of financial market dynamics.

We believe that courts will eventually discard both the bankruptcy public policy exception to the enforceability of waivers and assignments of ancillary bankruptcy rights and the consideration of “obstructionist behavior” as a factor to be considered. Instead, we expect courts will simply enforce agreements which are freely made amongst sophisticated parties according to the terms of such agreements. This would render an intercreditor agreement’s waiver or assignment of ancillary

80 It is possible that a bankruptcy public policy argument may still exist in the context of the waiver of ancillary bankruptcy rights by subordinate lenders under even in a single credit agreement. See In re GSC, Inc., et al., Opinion Authorizing Hearing on the Sale of Assets Adjourning Consideration of Disclosure Statement, and Approving Sale of Assets, pp. 46–47 and note 47, Chapter 11 Case No. 10-14653 (AJG) (Bankr. S.D.N.Y. July 18, 2011). 81 In re Shilo Inn, Diamond Bar, LLC, 285 B.R. 726, 40 Bankr. Ct. Dec. (CRR) 121 (Bankr. D. Or. 2002) (holding that only the trustee of a CDO and not an investor in the CDO has the right to vote the CDO’s claim in a bankruptcy case).

- 22 - bankruptcy rights unenforceable only under traditional contract law doctrines such as fraud, duress, capacity, illegality, unconscionability, and the Statute of Frauds.

We are available to discuss any of the concepts touched upon in this Bankruptcy Alert, or to assist in any bankruptcy cases and insolvency matters. If you have questions, do not hesitate to contact the following members of the Financial and Bankruptcy team:

 Mark N. Berman, Esq., 617-345-6037 or [email protected]

 David H. Lee, Esq., 212-940-3070 or [email protected]

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. It is always necessary to review specific transaction documents and identify the parties to the transaction. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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